By Peter Kinch
RBC led the charge last week to cut back on the discount they were offering off of the prime lending rate for Variable Rate Mortgages (VRMs). Up until last week, it was common for borrowers to get Prime less 0.75% or 0.80 % or in some cases even up to Prime minus 0.90%. With the Prime lending rate at 3%, this could mean an initial rate as low as 2.1% in some cases. But alas, that was last week and now the majority of lenders are offering Prime - 0.5% or less. In effect, they have made the VRMs a little less attractive than they were a week earlier.
So why did all the lenders follow suit and increase the cost of taking a VRM in today's market? Well the official reason that was put forth by the banks was that there was a lack of liquidity in the markets and the cost of borrowing had increased. Now of course, we'll all have to take their word on that since the average Canadian does not have access to the inner workings of a chartered bank and the true costs of borrowing that they incur. But I do know one thing for certain, given the limited exposure that I have, and that is the fact that many lenders have been grumbling for months about the lack of profitability on the Variable rate mortgages with such high discounts. In the meantime, what seems to have been lost in the conversation was the fact that the bond yields have been steadily dropping all summer long. This in turn, led to an increase in the profitability on long term rates. So while most of the country's media focused on reporting about the fact the Bank of Canada (BOC) will not likely be moving rates soon, no one was drawing attention to the fact that the banks' profit margins were steadily rising as the bond yields dropped. Lenders were making significantly more profit on a 5 year term than they were selling variable rate mortgages with full discounts.
So let me ask you a simple question; if you were running a business that had two products and one of them was very profitable and one of them broke even or even lost money, which would you promote? The end result is that banks would like you to take a five year fixed rate mortgage and are now making it more attractive for you to do so.
BY THE NUMBERS - Changing Spreads and Changing Guidelines
Talking about the price of a 5 year mortgage and the spread on the bond yields can be very confusing for the average Canadian. Since most people don't understand it the media tends to avoid writing about it. As such, some glaring discrepancies go unreported and questions remain unasked.
Let's start with some basics:
A bond yield and a bond price have an inverse relationship. Don't worry about trying to understand that - you simply need to know that if the bond price goes up, the bond yield goes down and vice versa.
Canadian banks and lenders use the bond yields to determine their 'spread' aka profitability.
They like to keep the spread between a certain range. For example; 5 years ago the spread would be between 90 and 130. That means you take the 5 year mortgage rate (say 4%) and subtract the current 5 year bond yield (say 2.95) and the difference should be between 90 and 130. If the difference is below 90, then that is a signal for banks to raise rates. If it is above 130, then they would lower rates. In the above example 4.00 - 2.95 = 1.05 so that would indicate the rate is within the 'comfort zone' and therefore not likely to move.
Now let's look at the way things are today:
Today's 5 year bond yield (at the time of writing and subject to change daily) is 1.66
A typical 5 year published mortgage rate is 3.59%
3.59 - 1.66 = 1.93
Now based on the numbers that were used 5 years ago by the chartered banks a spread of 1.93 would be .63 over the comfort zone - aka very profitable - and a signal to lower rates (arguably to as low as 2.96% for a 5 year term). However, lenders are no longer using the same model for spreads. In fact, due to (and I quote) "the uncertainty in the bond market is forcing a wider than normal margin until investors see some stability return" - the current range that lenders are going by is 1.75 and 1.95. As such, the spread of 1.93 for today's interest rates is actually at the high end of the comfort zone, but still within range. Some lenders are offering a quick close special of 3.39% which puts the spread at 1.73 and therefore out of the comfort zone. As such, any increase in the bond yield will result in those rates increasing, not decreasing.
Suffice to say, it would appear that the banks are making significantly more profit on 5 year mortgages today than they did 5 years ago. But having said that; they also experienced the global credit crunch of 2008 and saw first hand the impact to global banks when liquidity in the markets disappeared. And although we complain about the profitability of the chartered banks, it was this very fact that has made them the envy of the world when their counter-parts in other countries suffered. With ongoing credit and financial issues in Europe and the United States, perhaps the Canadian banks are wise to shore up their coffers while they can.
In the meantime, the more investors flock to safe harbours amidst turmoil and uncertainty in the global markets, the more bonds they will buy. The more they buy bonds, the higher the price goes and as such, the lower the bond yields go. Now, whether this will translate into lower mortgage rates for you is yet to be determined. And while we could argue that the long term rates could go even lower or in fact that they should be lower, they are still the lowest they've been in a lifetime. So whether you choose to take a variable with a lesser discount or today's low long term rate - one thing is certain: rates are low - if you have a mortgage or you're planning on getting one - take advantage of these low rates today and accelerate your debt reduction. Stability will eventually return to the markets and investors will eventually shift back to equities and when that happens, bond prices will drop, yields will rise and so too will your long term rates. In the meantime, enjoy them while they're here.
Happy Investing,
Peter Kinch
Peter Kinch is the author of The Canadian Real Estate Action Plan and co-author of the Canadian Bestseller - 97 Tips for Canadian Real Estate Investors.Peter Kinch Mortgage Team is located at Unit 201 101 Klahanie Dr. Port Moody BC V3H 0C3 Ph: 604 939 8326 www.peterkinch.com
