The 5-year Government of Canada bond yield fell today to a never-before-seen 1.28%.
Its 13 bps drop came on the heels of August job losses, a stock market selloff and more eurozone anxiety.
The spread between posted fixed rates and the 5-year yield (a very rough proxy for a lender’s base funding costs) is acting like there’s a credit crisis. But there’s not…at least not yet.
(Click to enlarge)
http://canadianmortgagetrends.com/wp-content/uploads/2014/04/6a00d8341c74cb53ef0153913bd8a7970b-800wi.jpg
Banks are keeping posted rates elevated, in part, to pad profits. They’re also building a buffer to ride out potential turbulence in funding costs (due to credit market volatility). There’s also speculation that they’re doing so to keep qualification rates high—so people can’t get into “riskier” variable-rate mortgages so easily.
In the 10 years prior to the credit crisis (pre-2008), the 5-year posted-bond spread averaged 237 basis points. If you applied that “normal” spread today, 5-year posted mortgage rates would be closer to 3.66%, instead of their current 5.39%.
On the bright side, inflated posted rates are keeping IRD penalties lower than they otherwise would be. That’s certainly a help to people breaking fixed-rate mortgages.
Posted rates aside, it is inflated discounted rates that are the real irritant. Today’s “discounted” fixed rates are in no way commensurate with banks’ astoundingly low funding costs. If you applied a typical 135 bps spread above today’s 5-year yield, you’d have a 2.64% five-year fixed mortgage. Instead, borrowers are being fed rates as high as 3.59%+!
Granted, there are slight liquidity premiums and IFRS premiums built into today’s rates (compared to pre-2008), but those in no way justify the mortgage spreads we’re seeing.
Banks are obviously not feeling enough public pressure yet to reduce their astonishingly high fixed mortgage margins. We’ll see if they feel any more generous next week…
Rob McLister, CMT
Last modified: April 29, 2014
All the more reason why I’ve been advising customers to go variable. Even if rates increased, they would have to increase by well over 1% before they equaled what fixed rates are at.
What I worry about is a currency crash – interest rates will be used to defend such an event and hopefully it can be avoided.
Any chance that 5 year fixed discounted rates will reflect these new lows, or are they just too low for banks to fathom?
as more and more of us leave banks maybe they will start to get the message — boys, lower your fixed rates!
Banks could be trying to keep customers out of risky loans? That’s a new one :)
Maybe the Finance Department is pressuring the banks to keep them out.
On the bright side, inflated posted rates are keeping IRD penalties lower than they otherwise would be.
Excuse me? How do you figure this, if Interest Rates are artficially high aren’t the the rollover rates also high and the same for the differential rate.
Ritchie you are incorrect. If posted rates fall, the differential between a borrower’s contracted rate and the lender’s current rate increases. Therefore the interest rate differential penalty increases.
@Suzanna, I don’t wish to be argumentative but you merely repeat what Rob seems to say. I don’t see the math; if my mortgage rate is x% and the Bank reduces its Interest Rate posted or otherwise from 2x to 1.75X% then where is the increase?
Ritchie – I think what Suzanna and Rob are referring to is the penalty people pay to break their current mortgage. The wider the gap between the rate someone is locked into and the current posted rate, the higher the penalty fee you have to pay to break your mortgage. For instance, I am currently in the process of refinancing my condo inorder to purchase a house, if the posted rate goes up next week, it will cost me more to break my mortgage than it does at this very moment (I currently have a few years left on a fixed rate). I see what you are thinking and yes, if rates go down then you will of course get the benefit of that BUT only if you decide to lock into a fixed rate. If you are converting from a fixed to a variable, then the lower the posted rates go, the higher the penalty you have to pay.
Sorry – I meant to say “if the posted rates go down next week it will cost me more to break my mortgage thatn it does at this very moment…”
Ritchie,
The IRD penalty compensates a lender when a homeowner excessively prepays a mortgage that has a higher rate than what that lender can earn today.
It mostly applies to fixed-rate mortgages but you’ll find it on a few variable-rate mortgages also.
In general, the further that today’s rates are below the rate the homeowner locked into, the bigger the penalty.
Here’s the math: Link
Here’s an IRD penalty calculator where you can test scenarios by entering different numbers for the lender’s “comparison rate.”
You bet – Scotia’s tiny posted rate drop increased today my IRD by two-thirds compared to what it was three business days ago.