Mortgage Rate Changes: How to prepare yourself?

Canadian MortgagesWith almost five years of historically low rates, in July we witnessed yet more mortgage rate changes in Canada that may not be so temporary. There was especially some upward movement in the 5 year fixed rate mortgages.  These changes have since leveled off, but this may be the beginning of the end of the historical low interest rate party. Many believe that the interest rates for at least the fixed rates may be on the rise.

According to a recent BCREA forecast, much of the rise in fixed Canadian interest rates may have more to do with what is going on in the United States than in the domestic economy. Regardless of the specific cause, there is anticipation of a modest increase of 5-year fixed-rates back to 5.24 per cent with the possibility of a further move up to 5.44 per cent if bond yields continue to rise.

In my last newsletter, we discussed the importance of managing risk around leveraging investments.  Strategic Investment Realty encourages our clients to be wise about using leverage and understand the risks of over-leveraging.

This month, I want to follow up and provide my thoughts on how the changes to the rules and policies for Canadian mortgages and bank lending guidelines can make it more difficult for buyers and real estate investors to obtain mortgages.

Fixed and Variable Rates

5 year mortgage rate vs. 5 year bond rate comparisonBefore we can understand the volatility behind interest rates, it is important to note how variable and fixed rates are calculated.

Fixed rates by and large are based upon the pattern of 5-year Canada Bond Yields, plus a spread. Bond yields are driven by economic factors such as unemployment, export and inflation.

When Canada Bond Yields increase, sourcing capital to fund mortgages is more expensive for mortgage lenders.  As their profit is reduced, they respond by increasing mortgage rates. The reverse is true when market conditions are good.

In terms of the spread between the mortgage rates and the bond yields, mortgage lenders set this based on their desired market share, competition, marketing strategy and general credit market conditions.

Variable mortgage rates are typically lower than fixed rates, but can vary over the duration of the term. Variable mortgages are prone to market behaviour (via the prime rate). The interest rate varies with changes in market interest rates (typically the bank’s prime lending rate), which is based on the Bank of Canada’s

With these changing rules there may be a silver lining for real estate investors.  As there are less people able to obtaining financing, the rental market continues to be strong.  With greater demand from renters, there is greater pressure on rents in those markets most affected.

Changes to Financing Rules – in Review

  New Canadian mortgage rulesAccording to a recent Maclean’s article, this spring, in order to “cool down” the housing market and protect taxpayers from financial risks, Canada Mortgage and Housing Corp. (CMHC) started to limit guarantees for banks and other lenders on mortgage-backed securities.

Banks, credit unions and other mortgage lenders were notified that they would be restricted to a maximum of $350-million of new guarantees this month under its National Housing Act Mortgage-Backed Securities (NHA MBS) program.

Federal Finance Minister Jim Flaherty, stated he would limit the ability of banks to buy bulk insurance from CMHC.  He also shortened the use of government-backed insurance in securities sold by the private sector.

These mortgage changes forced banks and other lenders to assume more of the risk of mortgage defaults, rather than offloading that risk to Ottawa. As predicted, Canada’s housing decelerated as a result of tighter mortgage insurance rules.

At the start of this year, after discussions with CMHC, Mr. Flaherty said there would be a guarantee of a maximum of $85-billion worth of new NHA MBS this year. By the end of July, lenders had already distributed $66-billion worth of the securities, compared to $76-billion during all of 2012.

Now, CMHC is levying the $350-million cap on each issuer effective immediately, while it determines a formal allocation process this month for the remainder of the year.

With the cap on lending in place, some lenders may need to look to private lenders. That means that some lenders may need to fund new mortgage through alternatives to NHA MBS and will be faced with higher mortgage funding costs. These higher costs would likely be passed through to mortgage rates. Preliminary estimates put the potential impact on mortgage rates in a range of 20 to 65 basis points (0.25% to 0.65%).

These mortgage changes directly relate to CMHC insured mortgages, but we may see some fall out impact to conventional (non-CMHC) mortgages.

The US Mortgage Market

US mortgages

With improvements from the US Employment Report and the Retail Sales report, mortgage rateshave shifted higher over August.  Rates were already on the move higher ahead of the data owing to bond market weakness in overnight.

Retail Sales are an indicated that the markets and the Fed itself will shift towards tapering and slowing securities purchases. The recent data “wasn’t bad enough” the context of the prospects for a reduction in the Fed’s asset purchases–aka “tapering.”

Because the asset purchases are seen as a mathematically quantifiable reason for lower rates, the sooner the reduction in purchases occurs,the higher rates will go, all other things being equal.

Similarly, European markets have also noticed upward momentum and if data confirms Retail Sales, rates could go even higher.

What does it mean for you?

As a real estate investor, it’s time to be more proactive with your mortgage financing.Securing financing will continue to become more difficult.  The new financing rules may make the purchase of your next investment may mean greater more difficult.

Many people secure a mortgage without fully understanding how adjustments may impact their bottom line. They know they are on a variable, but they may not have fully determined if they can cap their mortgage at a certain level or convert it to a fixed mortgage if necessary.

You need to understand if they you are going to break your mortgages – what is the effect and at what point does it make sense financially to do so.

Applied knowledge is power, and now is the perfect time to “get your mortgage ducks in a row”.

Top 5 recommendations for your mortgagesHere are my top 5 suggestions:

  1. Understand your risk.  Understand how your mortgages are structured and how this may impact your renewals and refinancing. Determine your cash flow requirements in advance of changes so you have money available to cover additional costs if necessary. For example, could you still afford payments if your five-year rate shifts to 5.4%? It’s better to run the numbers to create a buffer zone for your mortgages.
  2. Be proactive not reactive. Investors who have variable rates shouldn’t be too alarmed.  Interest rates are based on the prime rate which is set by the Bank of Canada.  The Bank of Canada has opted to keep its benchmark interest rate steady at one per cent on for almost three years, but there may be changes coming.
  3. Review renewal dates.  Ask your mortgage broker what and how you can take steps to minimize your risks and costs while optimizing your position with the renewal dates on your existing mortgages.
  4. Talk to a mortgage professional.  Speak to your mortgage broker or accountant to create a strategy to manage your risk. As mentioned above, some of these strategies may include staggering your mortgage renewal dates. They could involve breaking some mortgages and renewing earlier than the renewal dates with your current mortgages. They could involve changing the mortgage terms or amortization periods. They could involve steps and tactics not even mentioned here.
  1. Consider your mortgage payment options.  It may be the perfect time to review your prepayment options. It may make sense to employ some of you prepayment options. Increase your payments marginally now and periodically so that you are not in payment shock in relation to the increased rate upon your mortgage renewal. That way, you will reduce “rate shock” when your mortgage is up for renewal. Remember, any extra payments you make will go straight towards paying down your principal faster, which means you will be mortgage-free quicker!!

Now is the perfect time to review and determine how to respond if there is are mortgage rate increases as many expect.  Set a plan in place to effectively control and manage your payment for the next few years by running through some potential interest rate scenarios – so you determine and understand your risk.

Consider and ask questions about your current mortgages.  Review the following key items:

  • Cash flow
  • Amortization period
  • Interest rates
  • Payout penalties
  • Alternative solutions (such as multi-tiered mortgages)
  • Other contingencies

The Bank of Canada of adjustments may have a significant impact on your portfolio.  Make the best decisions you can, make them with a reasonable amount of input from professionals. Take time to talk to a professional before you rush to switch your mortgage into a variable or fixed rate.  Above all, know that over the long term, you need to balance your risk for all investments.

By Andrew Schulhof
26 Aug 2013