Are mortgage rates going to increase or decrease in 2019?
By Nick Holloway
To a casual observer, it is fair to say that we can reflect on 2017 and 2018 as being an increasing rate environment, but now I want to take a moment to summarise where we stand up to now, and what the outlook might look like going forward given some of the latest available macro-economic figures and forecasts. The base-line to understand what is moving mortgage rates is by reviewing the Bank of Canada overnight rate, as well as government bond yields. I will look to examine some of the key features of these underlying rates and some of the reasons behind the changes we have observed.
Lets start with the Bank of Canada, which started to increase, or tighten, its target for the overnight rate, also known as the key policy interest rate, from its low point of 0.5% in July 2017, with the final increase up to now during their October 2018 meeting to 1.75%. In turn, the Bank of Canada overnight rate is directly correlated to the prime lending rate which banks and lending institutions use in calculating interest payments on variable rate mortgages and lines of credit. It should be noted the Bank of Canada conducts 8 interest rate announcements each year, where the Banks committee decides whether to increase or decrease the overnight rate in line with its monetary policy objectives, and based on the last 13 meetings, we see 5 instances where the interest rate has been increased by a quarter percentage point.
The Bank of Canada had indicated as part of their forward guidance, they consider a neutral nominal policy rate, which it describes as a medium to long term equilibrium concept, to be somewhere between 2.5% and 3.5%. This range is largely driven by a desire by the bank that they have spare capacity to manoeuvre should a significant downturn occur, or in other words, they have the capacity to cut, or loosen, interest rates if needed to stimulate the economy. The Bank remain cognizant that by increasing the overnight rate too quickly, there is a possibility this may act as a catalyst which causes the economy to contract, so they continue to iterate that any future increases will need to be gradual and are very much data dependant.
The Bank of Canada has many aggregate data points at their disposal which they evaluate before deciding on changes to their monetary policy actions, some of which are outside the scope of this article. However, we can look at two of the main areas the Bank of Canada focuses on, being that of consumer price inflation (CPI) and real gross domestic product (GDP).
Firstly, one of the banks key objectives is to keep inflation at or around 2% per annum, because it is widely accepted that the economy benefits from a small amount of inflation, whilst also looking to avoid deflationary conditions. According to the Monetary Policy Report which the Bank released following their January 2019 meeting, it confirms in Q3 2018, we saw year-over-year inflation peak at 2.7%, but this has since receded to 2.0% for Q4 2018; the projections going forward for Q4 2019 and Q4 2020 remain at the 2% target.
Secondly, the Bank of Canada will consider the GDP number, expressed as a percentage, to understand if the economy is growing, as in a positive figure, or contracting, if the percentage falls below zero. For the Q4 2018 reported figures, the GDP year-over year increased by 2%, and is projected to dip slightly to 1.9% for Q4 2019 and increase for Q4 2020 to 2.1%. The report goes into more detail about some of the specific headwinds the Canadian economy is facing that may negatively affect inflation and growth going forward, noting financial market volatility, oil price declines and the slowing in growth in several key markets such as US and Europe, as well as emerging economies such as China. These headwinds might be temporary, but they are areas nevertheless the Bank is concerned about and will continue to monitor these risks on an ongoing basis.
To complete our picture, we want to look at changes in government bond yields, which is one of the key driving factors behind what rates are offered on fixed rate mortgages. To provide some context based on economic theory, a government bond, or more importantly, its yield, is considered the risk-free rate of return for a given dollar amount expressed as a percentage. In a sense, it provides a yardstick for investors to determine their required rate of return in relation to the specific risk profile of a given investment. To use an example, an investor can choose to accept the rate of return from a government issued bond knowing that their investment is virtually risk free, whilst a different investor may choose to invest in a mortgage backed bond, which by its nature is considered a relatively low risk investment, however the achievable rate of return from the mortgage bond should inherently be higher than the government bond in order to compensate the investor for assuming the increase in capital risk.
What we can see by looking at recent changes in the bond yields, these have increased over 2017 and 2018 period which is somewhat in-line with the changes observed in the overnight rate, with the bond yield peaking around October 2018, and has come off this high towards the tail-end of 2018. Historically, bond yields provide one of many key indicators of future inflation expectations that are effectively being priced into a tradable market. So as bond yields move higher, there is an expectation of higher inflation, which is a function of the demand by investors for an increasing rate of return, in real terms, which allows them to offset the capital erosion brought about by higher inflation. The same holds true in reverse, meaning as expectations of future inflation are decreased, the bond yields will typically respond by moving lower.
So, what should we expect in 2019? That is indeed the $64 million-dollar question and it is important to recognize that some of these figures are based on projections, given it would be impossible to offer a definitive answer as to what the future holds with so many different moving parts that make up the economy. This does however help to illustrate some of the keys areas to keep an eye on in order to interpret, at least with an increased probability, what direction the economy may take going forward. As the proverb says, to be forewarned is to be forearmed.
Not all mortgages are born equal. Be aware of the “No-Frills” mortgage?
By Nick Holloway
When you are reviewing your mortgage options, it is important to understand the terms and conditions which are contained in the mortgage being offered. Within the mortgage industry in Canada, there is a wide variety of choices when it comes to selecting lenders and products. As a mortgage professional, it is an important stepto understand and review all the options available to us prior to providing lender suggestions to our clients, and then taking the time to explain all the details which are contained within the terms of the suggested mortgage. We are frequently moderating these choices for our clients based not solely on rate, but also by looking at what restrictive terms might be included within the mortgage contract.
What is a No-Frills mortage?
A No-Frills or Low Rate mortgage typically indicates the mortgage contract has certain restrictions which you would not typically expect to see in a standard mortgage contract. Certain examples include that full repayment of the mortgage prior to the end of term is not permitted apart from by the sale of your property in good faith to an arms length buyer, or commonly referred to as a Bona-Fide sales clause. Other restrictions which may accompany this same clause might state that once you reach the end of your initial mortgage term, you are only permitted to renew your mortgage to a new mortgage term with the same lender. As you can see, both of these clauses in place systematically restrict the borrower from securing a more competitive rate from the wider mortgage market should they so choose.
What are the benefit of going with a No-Frills option?
One benefit you are likely to receive is that the rate offered on your initial term is typically lower when opting for a No-Frills mortgage. To put this in perspective, you want to understand what a difference a rate reduction is going to make to what you pay on a monthly basis. So lets say we are looking at a 0.05% reduction (5 basis points) on a standard mortgage rate per $100,000 of borrowed funds, and want a quick way of understanding this change as reflected on your monthly payment. The reduction per your monthly payment in this scenario is a total of $2.64, so around the same cost of a cup of coffee. With this in mind, you can convert this figure accordingly based on the amount of borrowed funds, then multiplying by each 0.05% change in rate to ascertain the full ongoing cost increase. It can sometimes be helpful to think of what this additional cost is in the same way as how an insurance policy works, which is a premium to protect you for lifes unexpected twists and turns.
Is the trade-off ever worth it?
In most cases, the trade-off for being in a restrictive mortgage will typically not outweigh the rate reduction you might obtain on the initial term, however there might be specific circumstances where the benefit is sufficient to at least have some consideration assuming a full comparison is made. It is important to note that by working with a mortgage professional, we want to understand what our clients real estate goals are now and going forward. We are here to put in place for our clients a comprehensive mortgage plan which covers all your available options,and also to act as a guide afterclosing so that we may help our clients in the future.
So in conclusion, if you want to pick up from the grocery store a No-Frills tin of baked beans then you do not need to give this much thought, in fact as my business professor told me once, the tin probably comes from the very same factory as the branded variety. If you want a No-Frills mortgage, always remember, Caveat Emptor.
If you have any questions and want to discuss your own mortgage goals with me, please let me know, I would be happy to be your guide.
How does a quarter percent rate increase in mortgage payment affect a typical household budget?
By Nick Holloway
As had been widely anticipated, we saw the Bank of Canada last Wednesday increase the overnight borrowing rate from 1.5% to 1.75%. The resulting change in the bank prime rate which most variable mortgages and line of credits are determined by, increased by the same quarter percent from 3.7% to 3.95%. It should be noted that fixed rate mortgages are largely derived by underlying government bond yields, the increases of which have largely been priced into fixed rate mortgages following rises in bond yields over the last 6 to 12 months.
The question I wish to address here is the proportional effect of a quarter percent increase on a mortgage rate in relation to a typical household budget. To find a baseline for my case study, I have decided to take the average household income and average house price level in the Ottawa region from the 2016 census figures, which are $102,000 and $394,000 respectively, and setting our rate parameters at near current levels.
What is the households take-home pay per month?
I want to be conservative with my figures, so I will establish the actual take home pay, opposed to gross pay when household income is set at $102,000. By assuming a single Ontario salaried tax payer in the household with no other incomes such as investment returns, tax refunds, tax credits and the like, results in an annual net figure of $73,272, or $6,106 per month which we shall call the overall household monthly budget.
What is the households mortgage payment per month?
At a typical current mortgage rate of 3.5%, for every $100,000 of mortgage on a 25 year repayment schedule, the principal and interest mortgage payment is $499.27 per month, increasing by $13.29 to $512.56 at a 3.75% rate. I again take a conservative approach in my assumption on the current remaining mortgage balance, and for the equity built into the home of 20%, provides a mortgage balance of $315,200. We plug in using the same mortgage rates and the monthly repayment amount initially was $1,573.70, and increases by $41.88 per month to $1,615.58. In percentage terms, the mortgage payment has increased by a factor of 2.6%. It should be noted the percentage increase is the same whether you consider the timeframe on a monthly, yearly, or lifetime basis of the mortgage. In other words, the way an amortization schedule for a decreasing balance works, this percentage change does not compound year over year, it is simply the overall cost of the mortgage, or the sum of each and all outstanding principal and interest payments will increase by this factor and this factor alone.
What is the share of shelter costs against take home income, and by how much is the overall household budget reduced by this change?
From the above, we divide the mortgage payment of $1,615.58 by the net income of $6,106 to provide a percentage of take home pay devoted to shelter of 26%, in other words a little over a quarter of the household budget being used for the mortgage payment. We also want to work out in percentage terms how much the monthly mortgage payment increase of $41.88 will reduce the overall household monthly budget of $6,106, which equates to a decrease of around 0.7%.
How does this 0.7% decrease in overall household budget compare to projected inflation rates and wage growth?
According to the accompanying Bank of Canadas October 2018 Monetary Policy Report, the projection for CPI (Consumer Price Index) inflation (year over year) for Q4 2018, Q4 2019 and Q4 2020 are 2.3%, 2%, 2% respectively, which is roughly aligned with the target annual inflation rate of 2% which the Bank of Canada has mandated for. When you compare the increased compounding effect of these projected inflationary figures which are in turn closely aligned to the Bank of Canada projections for annualized wage growth over a similar period, you can see a single quarter percent change is significantly less than the projected wage increases one should expect to realise. The report also indicates the Bank of Canada expect rates to increase gradually to a neutral rate of between 2.5% and 3.5%, we currently stand at 1.75% and are three quarter percentage point increases from reaching the lower end of this range. If the economy continues to operate at full capacity which is a condition required by the Bank of Canada to support further rate increases, it is reasonable to expect that employment gains and corresponding wage growth will continue to increase as projected. By this analysis alone, one could say the effect of this increase in mortgage payment might be largely negated by the virtue of annualized and compounding wage growth over a corresponding time period, and potentiallyfor subsequent increases as well. On balance, I expect the reality of a somewhat marginal change in household budgets might be less spectacular than the mainstream media headlines would have us believe.
If you have any questions and want to discuss your mortgage or how your own numbers are affected by these changes, I would be happy to help.