What you will learn in this article:
1) How mortgage rates work;
2) What is happening to mortgage rates now; and
3) How to protect yourself from higher rates and tighter mortgage lending now
As we all know, real estate financing plays a central role in the affordability of real estate to most Canadians. In fact, every 1% increase in residential mortgage rates literally ends the dream of home ownership for thousands of Canadians. When these rates play such an integral role in the availability of housing for Canadians, it is surprising on how much they are misunderstood.
To understand what is occurring in the mortgage market, one must understand how it interacts with the overall market for funds (commonly referred to as the capital market).
The very cornerstone of the capital market is simply this: at any one point in time, some segments of the economy have surplus capital (investors) while others in the economy have a use for that surplus capital (borrowers).
The Capital Market
The capital market, as it is defined, refers to the market that facilitates the transfer of funds from those who have excess to those in need (savers to borrowers). One of the largest determining factors of the supply and demand for funds is the interest rate that governs the process. This provides a measurement for the reward of saving, while providing the cost of borrowing. The equilibrium interest rate is the point where there is a close balance between the amount borrowed and the amount saved. In economic terms, the interest rate is the ‘price’ of borrowed money.
Canada’s Mortgage Market
In the past, banks primarily lent mortgage money from the deposit base of their customers. In today’s market, this is no longer the case. Today, much of the bank mortgage lending comes from their own ability to borrow from debt capital markets (often mortgage backed securities).
The debt capital suppliers have the primary responsibility of making sure that they preserve the capital of their investors, while getting a fair rate of interest for the money they lend based on the amount for which it was lent. The key driving forces behind the cost of that money (interest rate) is the relative creditworthiness of the borrower coupled with the expected rate of inflation for the period the money is being ‘used’.
Mortgage Pricing
As always, the risk return trade-off holds true in the marketplace. In order to lend money out to higher risk areas, the debt capital suppliers must be able to command a risk premium (extra return) for enduring that risk. This premium is factored in through a higher interest rate. So how are almost perfectly secured investments like prime residential mortgage rates priced the way they are?
The comparison is quite simple. Commonly in the financial markets, government backed financial instruments serve as the entry point being viewedas the risk-free investment. Governments have almost zero default risk (with a few recent notable governments excluded) through their ultimate ability to increase our taxes and control money supply (among many other variables). At a basic level, short-term rates move with the Bank of Canada’s overnight rate (and the Bank of Canada typically meets to set rate eight times a year), while longer-term fixed rates are tied to the government bond market. The Bank of Canada can influence long-term rates – it does not have control over it. This key difference in how rates are determined is the reason we don’t always see short-term and long-term rates moving in unison.
In the case of variable rate mortgages, that borrowing rate is usually the overnight lending rate set by the Bank of Canada that determines the retail banks’ prime lending rate, of which the variable rate discount trades off. In this case of fixed rate mortgages, that comparative instrument is the federal government bond. Today, the largest determining factor is the relative price of the government bond for the term of the mortgage selected.
In order to encourage those who invest in debt capital to invest in mortgages over government bonds, there must be a premium .. giving a reward for the extra risk associated with investing in mortgages. This risk in financial terms is referred to as the spread. The spread effectively determines the premium charged for investing in mortgages instead of government bonds. This spread must consider all extra costs incurred to fulfill a mortgage portfolio as well as factor in a profit. What you will find is that these spreads generally remain constant in one short period of time.
The last year has been confusing time in mortgages for three key reasons:
1) The rate of the projected increases by the Bank of Canada has been repeatedly revised and it makes it very difficult to select between a fixed and variable rate product.
2) Since November the Government of Canada bond has gone down but we have not seen much decrease in the level of mortgage rates.
3) Mortgage credit rules got much tighter at the beginning of the year and seem to be only getting more restrictive
What the Bond Market is telling us based on market conditions:
Long-term bond rates are trending down for two key reasons:
- Inflation seems to be mostly contained at this point.
- The Canadian economy has been showing some more signs for concern with oil prices going down and a lot of uncertainty in the global economy. Long term yields going down show concern about long term economic growth.
What should mortgage consumers do with their mortgage borrowing?
Regardless of whether rates stay up or go down, I can say with almost full certainty that the Bank of Canada will raise rates further in 2019.
- Fact – in the Canadian mortgage market when rates go down you get the benefit of the lower rate – thus, the benefit is to apply for any mortgage you are considering now.
- Fact – if mortgage rules get more lenient (highly unlikely) then you will get the benefit of the more lenient rules even if you apply for a mortgage today using the current rules – thus, the benefit is to apply for any mortgage you are considering now or to process your refinance or renewal sooner.
We can’t stop any mortgage rule changes or change market conditions, but you can prevent much of the negative impact by getting full approvals in place to protect your interests (quite literally) in advance of rate and rule changes. The translation – getting approved sooner rather than later is always the more cautious and more profitable route.
Canada is an export driven economy and predicting our interest rates at an accurate level beyond a very short period is an impossible task. Talk to our office today to determine what we can do to protect your payment shock at renewal time or qualify for a rate that is the best possible scenario before you purchase a home, renew a mortgage, or refinance.
Call our office today at 416-410-9905. We would love the opportunity to do a complimentary mortgage review to see if we can save you money or help increase you longer term wealth. You can also email us at clientcare@mortgagemanagement.ca