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.

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*  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.

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Rob McLister, CMT