Let’s talk about some market opportunities due to the recent fixed interest rate hikes and forward guidance by the Bank of Canada.
Before we dive into the opportunities, let’s understand/review the fundamentals so the opportunities crystalize (my intention anway :-)).
Fundamental Understanding:
- Fixed Rate Movement. Mortgage lenders make a profit on money they lend for residential Mortgages (shocking). A part of bank profit comes from the difference between bond yields and fixed interest rates. This spread or margin is a part of their profit.
Fixed interest rates move based on the government of Canada bond yield. Increasing bond yields compress Mortgage lender spreads/margins so they raise rates to regain their profit. When bond yields sink banks can maintain rates and take increased profit, or reduce interest rates to maintain profit margins. - Variable Rate Movement. The Bank of Canada moves the key overnight lending rate based on many macroeconomic factors to influence the overall economy. Movements of this key lending rate influence commercial banks (RBC, TD etc) prime lending. Prime lending rates influence the movement of variable Mortgage rates.
Key takeaway; the Bank of Canada considers the broad economy when moving rates up or down. - Mortgage Penalties. Banks charge the greater of a three month interest penalty or a interest rate differential penalty (IRD) penalty.
Three month interest penalties are, just that …the sum of three months of interest on your Mortgage (based on your Mortgage balance and interest rate).
Interest rate differential penalties are more complex and subject to each lenders policy, which can vary greatly (link to blog post). Generally speaking, IRD penalties take the difference between the clients current interest rate and the market interest rate of the remaining term of the Mortgage. This interest difference is factored into the Mortgage penalty -> hence the name interest differential penalty.
The gift and the curse of artificially low interest rates is they increased the spread between previous market rates and current market rates. This larger spread has produced very high IRD penalties.
Market Opportunites:
With the above understanding, let’s discuss some market opportunities
1) Lower Mortgage Penalties.
Fixed interest rates have spiked in the last several weeks in Canada. Why? The bond market of the economic elephant south of our border, has risen, pulling Canada’s bond market higher with it.
10 year U.S. treasury yields have risen steeply due to reasons I’ve outlined in this blog post (link).
Understanding this movement of bond yields, and how IRD penalties are calculated, creates the possibility of Mortgage penalties to be shrunk.
One might argue, if rates are higher I have missed the boat on the low fixed interest rate party? (I wrote about fixed interest rates here (link)). Possibly, the best fixed rates are behind us, but we still have variable rates to consider!
2) Variable Rate Mortgages!
I find that variable rate Mortgages are like salads when ordering dinner at a fancy steakhouse with a group of friends. All of my friends just ordered some delicious cut of meat. The server is now standing over my right shoulder, pen and curled notepad in hand, asking “and yourself sir??”. I know eating vegetables is good for me. I eat vegetables at home. I like vegetables, but that Chicago seared, medium rare steak is calling for me.
Steak is a easy and safe order. However, that steak is more expensive than it was a couple months ago. Nothing is wrong with that steak, but now the price of it on the menu creates questions about value in my mind. Perhaps I should ask the server what else they recommend?
Where I’m going with this is… many buyers come to me wanting fixed rates. Fixed rates just became more expensive though. Let’s talk about other menu items …
Benefits Of Variable Rate Mortgages:
1) Clearance pricing. As part of a multi-prong stimulus package due to the pandemic (blog link), the Bank of Canada has dropped the key lending rate to 0.25%. Next stop 0%? Commercial bank prime rate is at 2.45%. Variable rate Mortgages, priced on the prime rate, are discounted by up to 1% making variable rate Mortgages 1.45%. Clearance pricing.
2) Forward guidance is favourable. As mentioned above, the Bank of Canada moves their key lending rate based on the overall economy. Based on repeated content from the Bank of Canada, their forward guidance remains constant …rates are forecast to stay low until the economic recovery is well underway. Well underway means not raising rates until after the U.S. Federal Reserve raises their key policy rate. Remember, economic elephant south of our border. Well underway also means until slack in the economy is absorbed AND the Bank of Canada is meeting the 2% inflation target. Today’s prediction is meeting these targets in 2023.
3) Consider the servers dinner recommendation. If people are comfortable paying higher fixed interest rate prices, ok. One idea might be go with the clearance pricing of the variable rate Mortgage, but set your Mortgage payment at the higher fixed rate price. This way, if variable rate Mortgages do increase (and they will) your payment stays the same. When variable rate Mortgages increase, the amount going to principal versus interest would only change – not the payment. All payment dollars above the required variable rate, go directly to the principal paydown of your Mortgage. This might be a great opportunity to order a steak but have the health benefits of ordering a salad.
Conclusion:
Markets ebb and flow which create opportunities. One opportunity I’m seeing is reduced penalties because of higher interest rates. The spread between fixed and variable rate Mortgages is also widening strengthening the case to choose variable rate Mortgages (or some hybrid version).
If you received any sort of value or entertainment from this content, I’d appreciate you sharing this with your network. Comment below with any questions or your thoughts. Creating this content for you does take some time and effort so I appreciate your support.
Reach out if you are planning to sell, purchase or require any other Mortgage need. Direct: 403-809-5447 or chad@canadamortgagedirect.com.
Thank you,
Chad Moore
