Last November the banks decided not to raise their 5-year posted mortgage rates, despite raising their discounted rates.
Their stated reasoning was to bring posted rates more in line with discounted rates. In that way, their posted rates would appear more competitive.
As we wrote before, however, the decision had far greater implications than that. Among other things, it affected qualification rates, penalty calculations, and cash-back down payment mortgages.
Here’s a deeper look at the impact…
Qualification Rates
Lenders use the qualification rate (currently 5.19%) to determine if you can afford a higher payment in the event that rates rise.
The government mandates that the qualification rate be used when approving all high-ratio mortgages with a variable-rate or a 1- to 4-year term.
Had the banks raised posted rates along with discounted rates (as they normally do), posted rates would be 45 basis points higher today—5.64% instead of 5.19%.
At 5.64% it would have taken about 5% more income to qualify for a high-ratio variable-rate mortgage. Granted, five percent doesn’t sound like much, but if posted rates were suppressed another 1-2% the qualification rate would lose much more effectiveness.
It will be interesting to see how long banks keep posted rates at 5.19% in the face of further rate increases. As noted, doing so would handicap the government’s qualification rules…..unless, of course, something were done to offset lower posted rates—like implementation of a new qualification formula or a lower amortization limit.
One would have to imagine that the Finance Department is fully aware of the banks’ posted rate intentions at this point.
Penalty Calculations
As posted rates go up, interest rate differential (IRD) penalties often go down.
It was therefore disappointing to many potential refinancers to see banks hold down their posted rates. The move has cost some people literally thousands of dollars.
Mortgage broker Steve Garganis recently ran some numbers on how penalties were affected by the banks’ actions (you can read them here). Garganis used TD’s IRD formula in his example but TD is not alone. Other lenders (e.g., RBC, BMO, etc.) also use posted rates in their penalty calculations.
Banks definitely had the penalty effect in mind when deciding to hold down posted rates. On the other hand, today’s 5-year posted-bond spread is still wider than its average prior to the credit crisis.* Therefore, one might say the banks are bringing posted spreads more in line with historical norms. In turn, the higher penalties people are paying today are due more to fatter discounts off of posted rates than to historically small spreads.
While current fixed-rate mortgage holders may not be thrilled by all this, future borrowers might be largely unaffected. That’s because, going forward, spreads and posted rate discounts will likely change at the same pace. In that case, future borrowers shouldn’t have to endure IRD penalty calculations that are significantly worse than today.
Cash-back Down Payment Mortgages
Cash-back down payment mortgages are basically the equivalent of 100% financing, with a few more strings.
First off, the rate is higher. Today’s cash-back down payment mortgages generally sell at posted rates.
Insured 100% financing was usually offered at or near a lender’s best rates.
Secondly, cash-back mortgages have a clawback on the “free” downpayment. This means the bank takes back a pro-rata share of their cash if you break your mortgage before maturity.
Insured 100% financing ended in Canada on October 15, 2008 (see Goodbye to 100%/40-year Mortgages). Since then, cash-back down payment mortgages have been the only real option for those wanting a mortgage with zero down.
Essentially, the lender “gives” you 5% to use as your down payment, and you then mortgage the other 95% LTV at posted rates.
Therein lies the interesting part: banks have effectively “discounted” posted rates by 45 basis points in the last 7 weeks. That means cash-back down payment mortgages have actually become cheaper since November, relative to 95% financing.
In fact, if you factor in the 5% to 5.5% down payment that the bank is giving you “free,” the effective rate of a cash-back down payment mortgage is roughly 4.09% to 4.20% depending on the lender.
Compared to the banks’ current “special offer” rate of 4.24%, 4.09% seems like a steal. Even compared to a deeply-discounted 3.79% rate, a 40 bps premium for zero down seems reasonable.
Mind you, unless you are relatively debt free, have emergency savings, are well-employed, expect good income growth, and absolutely must own a home now, cash-back downpayment mortgages are a bad idea.
Rent and scrounge up a down payment instead.
* The 5-year posted-bond spread was 273 basis points as of Friday. That compares with an average of 239 bps from 1999-2007 (before the credit crisis). Data courtesy of the Bank of Canada.
Rob McLister, CMT
Last modified: April 25, 2014
It seems like the banks benefit in several ways from this (at least if they want to encourage cash-back mortgages). They are aware of all these factors – but it’s hard to say which one would actually come out on top and motivate the move.
Great technical analysis Rob. Your unbiased view is why I visit your site often.
Great post!
I find it fascinating that 100% financing is still available and so cheap! I always thought it was ridiculous to pay posted rates on cash back mortgages but I forgot to account for the 5% the bank is handing you. Very interesting information. Thx.
From my experience, banks will almost never change a policy and will almost always make the decision that makes them the most money.
> Mind you, unless you are relatively debt free, have emergency savings, are well-employed, expect good income growth, and absolutely must own a home now, cash-back downpayment mortgages are a bad idea.
In your experience, what ratio of cash-back mortgage home buyers don’t fit that criteria?
Hi WJK,
We haven’t done that many CBDP mortgages so our experience may not be representative. There’s probably a certain minority of people that shouldn’t be getting them. Generally, those people don’t have bad credit or other obvious risk factors. Instead they tend to have minimal liquidity as a fall-back if things go bad.
Fortunately this isn’t a pressing issue because CBDP mortgages comprise a tiny slice of the market. Moreover, I can tell you from experience that insurers and lenders are extra-careful when underwriting CBDP files. For example, borrowers with obvious risk factors (high debt utilization, high TDS, sub-700 credit and/or unestablished employment) tend to have a tough time getting approved (as they should).
Cheers…
Rob
Many thanks Brian!…and to MK below as well.
Question: does this mean that no matter what your income is, the maximum mortgage you can get is based on the 5.19% rate?
for variable & 1-4 yr fixed w/ downpayment of less than 20%).
Excellent article. In depth and well thought out. I especially love the final comment: Mind you, unless you are relatively debt free, have emergency savings, are well-employed, expect good income growth, and absolutely must own a home now, cash-back downpayment mortgages are a bad idea.
Rent and scrounge up a down payment instead.
That’s sound advice!
Your research and analysis is, as usual, spot on. I continue to be impressed with the quality of this newsletter. I can’t imagine where you find the time to actually make a living as a mortgage broker as well.
Good work.
If banks keep posted rates at 5.19% after the next rate increase then I’d take that to mean they have the Fin. Dept’s blessing.
Hi Vonny,
That’s correct. 5.19% is the qualification rate for all high-ratio insured financing with a variable rate or 1-4 year term.
For low-ratio financing, however, you may be able to qualify at a lower rate (e.g., a 3-year discounted rate versus the 5-year posted rate). It depends on the lender.
In either case, the qualification rate is used to calculate your debt ratios. Therefore, if you have more income, your debt ratios decline and, other things being equal, it’s easier to qualify.
Cheers…
This may be odd, but where did you get that picture of the guy lifting up the sheet? It is brilliant!
I’m wondering if there is another possibility – are the banks refusing to to raise their five year rate and the effective qualification rate as part of their negotiating strategy with the government over tougher mortgage rules? In other words is this their way of showing that they won’t automatically go along with Finance rules? The major banks are the main beneficiaries of shorter amortization periods or other proposed draconian rule changes. If the rule changes goes through the banks will able to increase their market share of quality mortgages while pushing much higher rate and higher risk credit card and personal loans, thus reducing competition while grossing up their overall loan margins. Its a great strategy for them – but everyone else in the country will suffer. Hopefully Flaherty will show that he is more than a pawn of the major banks.
I have to agree the the qualification method of using 5.19% (todays qualifying rate) since most Canadian home owners are strapped as it is, the lender needs to sort of be Mom and Dad and protect the borrower from increased rates in the future. However, I disagree that it is used on fixed mortgages under 5yrs. Since well, the rate is FIXED and therefore your payments will not fluctuate during the term.
“Most” Canadian home owners are not “strapped.” Many, yes. Most, no.
People who pay their bills don’t need the government telling them how to run their personal financial affairs.