Central banks have been lowering interest rates across the board to support our flagging economies. Nevertheless, how will these actions affect residential mortgage rates today? There are a few factors that come into play that dictates what banks will do shortly, and I will show you how to use that information to beat the banks at their own game.
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The central bank provides liquidity- use it to your advantage.
Central banks are responsible for maintaining the inflation rate within a certain percentage. In Canada, that percentage is between 1% and 3%. The objective is to ensure that the value of the economy grows at a steady and controlled pace. The Canadian central has an arsenal at his disposal when it deems necessary to influence the path of our economy. Regardless of the weapon used in its arsenal, they all affect the availability of money or lack thereof. The term coined in macroeconomy is the money supply.
How it all works together is relatively straightforward. If, after an analysis of the current and future economic situation, the central bank thinks we’re in a full-employment environment with a high pressure on prices and wages (inflation), it will decrease the money supply by raising interest rates. If, after analysis, it thinks we’re in an opposite situation, it will increase the money supply and inevitably decrease the interest rates. The latter is the situation we’re in right now in Canada.
Hence, the central banks provide liquidity mainly to banks and the market in general. If market conditions worsen, banks look to the primary bank to give them money so they can continue about their business. As you might have heard, the central bank has lowered its daily financing rate to 0.25%. That rate decrease should have had an immediate effect on all the loan products banks offer.
Unsurprisingly it did not. Why? Well, that’s where the risk factor in mortgages comes in play.
Key takeaway: In an economy that’s expanding, choose a fixed-rate mortgage.
The risk factor in residential mortgage rates today
Let me tell you how mortgages work in a nutshell. The central bank expects all banks to keep in their accounting books a portion of their assets in cash, i.e., 5% or 7.5%. That cash usually comes in the form of deposits from clients like you and I. The objective of banks is to lend as much money as possible at the lowest risk to them. Hence, the whole concept of credit score, but that’s a subject for another time. If you wish to know more about how credit score works, please read my article: What is poor credit and where do you find your credit report.
In a bleak situation like the current one with COVID-19, there are a multitude of unknown variables. The economy is at a standstill; people are losing their primary source of income, and thousands upon thousands are asking for payment delay on their mortgage.
A five-year mortgage is like a 5-year safe bond, or at least it used to be. A Bond is a financial instrument that usually provides semi-annual payments to the person who owns it. Just like a Bond, a mortgage gives a reliable stream of monthly income to the owner.
My mortgage belongs to who??
The owner of your mortgage might not be your bank but a Saudi sovereign fund. As an international investor, he requests a minimum percentage return on his investment. Inflation, the risk-free rate and a premium for risk all influence the percentage or yield demanded by the investor. In a mortgage, the possibility of defaulting on his payments impact the premium required. With all economies more or less shut down, financial institutions are having a difficult time assessing what the incentive for risk should be. Hence, when the central bank decreased its interest rate, the banks did not follow suit. They did not want to lend more money because they were scared of not being able to get paid back. The premium requested for risk increased, and that transferred to mortgages increasing their rates instead of lowering them.
Remember what I said about the responsibility of the central bank. In case of turmoil and economic uncertainty, it will increase the money supply to control consumer prices and wages. One of the weapons it will use is to lower the interest rate rapidly like it’s doing now. How to take advantage of it, choose a variable rate mortgage.
Key takeaway: In an economy that’s contracting or uncertain, choose a variable rate mortgage.
Refinance now and benefit from a lower interest. Really?
At this point, everybody should be aware that there’s a substantial downward pressure on mortgage rates. Even with that information, is the right time to refinance or to renew your mortgage early?
When you decide to break your mortgage contract, it will trigger a prepayment penalty. That prepayment penalty is usually the higher between:
- Three months’ interest on your balance or;
- The interest rate differential.
It’s imperative to ask your broker or your mortgage adviser about the ultimate cost of breaking that mortgage contract. There’s a simple mortgage penalty calculator that you can use on Rate supermarket.
If the prepayment fee is $2000 and it allows you to save $4000, then by all means, break that contract and switch banks if necessary.
Key takeaway: Refinance or renew your mortgage but don’t forget to take into account the prepayment penalties that can be quite hefty.
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Where can you find the lowest interest rate in Canada?
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RELATED ARTICLE: LOWEST INTEREST LOAN IN CANADA AND WHERE TO FIND IT.
Beat the bank. How to win the mortgage game in Canada?
I recommend this book to anybody who wishes to learn more about how mortgages work in Canada and what they can do to help them save thousands of dollars.