Mortgage Qualification Rate is reduced from 5.34% to 5.19%, why is this important?
By Nick Holloway
Following anannouncementby the Bank of Canada, the Mortgage Qualification Rate (MQR) will be reduced by 0.15% from 5.34% to 5.19%, or 2% above contract mortgage rate (whichever isgreater). This is the first reduction we have seen in the MQR since it was last increased in May 2018.
To provide a brief recap, the MQR was introduced as part of the B20 guidelines with the express intention of diminishing the amount home buyers can qualify for in respect of mortgage financing. This was initially rolled out for high ratio mortgages (down payments less than 20%) effective from October 17, 2016, and later revised to include conventional mortgages (down payment more than 20%) effective from January 1, 2018. The net effect of these changes for all federally licenced lenders was widely reported to reduce purchasers buying abilities by approximately 20%, in comparison with previous qualification rates - which would have been based on the mortgage contract rate at the time of securing the borrowers mortgage commitment.
How is the Mortgage Qualification Rate calculated?
The Bank of Canada release the benchmark posted 5-year rate every Wednesday, which is based on the mode average of the big 6 (chartered) banks posted 5-year fixed mortgage rates. Whilst the mode average is currently split equally at 5.19% and 5.34% respectively, the Bank of Canada took a view on the overall asset changes in aggregate and determined the 5.19% was a more appropriate rate to prevail.
Why does it seem the chartered banks are permitted to determine the mortgage qualification rates?
This isan interesting question as towhy the regulators decided to use these rates to determine a qualification benchmark at the outset of setting the new mortgage rules. First we should look to understand the reasons why the chartered banks require a 5-year posted rate in the first place, when the reality of what most borrowers receive byway of a closed 5-year fixed mortgage rate is generally far lower than the comparable 5-year posted mortgage rate. We should consider that often the first time a borrower is likely tosee their chartered banks posted rateis when they find they needto break their closed fixed rate term mortgage early for whatever reason.The borrower is then required to pay apre-payment penalty based on an Interest Rate Differential (IRD) calculation, which is generally not calculated from the borrowers actual mortgage rate, butthe elevated posted rate (or using the discount received from the banks posted rate) which typically has the effect of amplifying the penalty the borrower must bear in favour of the chartered bank.
What isthe effect of a 0.15% reduction in MQR for mortgage qualification?
For borrowers who find themselves at the limit of qualifying, this will increase the amount they can qualify for. In the same way that the 2% increase in mortgage qualification mentioned earlier had the net effect of reducing a borrowers purchasing power by around 20%, here we can apply the same logic in reverse. Areduction in the MQR of 0.15% translates to an increase of a borrowers purchasing power of1.5% -in other words, home buyerscan qualify for around 1.5% more property.However, it poses the questionwhether this goes far enough considering we have recently seen far greater decreases in rates offered on fixed term mortgages, which have not been reflected equally in the chartered banks posted rates.
Nevertheless, a small victory is a victory after all.
Bank of Canada holds Policy Interest Rate at 1.75% at April 24th 2019 meeting
By Nick Holloway
As had been widely expected, the Bank of Canadas latest monetary policy statement was released today with no change to the overnight lending rate. The overnight rate remains at 1.75% after Canadas central bank last made an increase in October 2018 from 1.5%. The Bank also lowered the neutral overnight rate from 2.5%-3.5% to 2.25%-3.25%.
Accompanying the announcement, the Monetary Policy Report was issued which provides some of the key figures the Bank of Canada is tracking. The first being inflation, which remains close to the target of 2%, with a dip in CPI inflation predicted for the 3rd Quarter. The Real GDP figures forecast growth in 2019 of 1.2%, and around 2% in 2020 and 2021.
So, whats causing this pause in interest rate increases, and is there any scope based on the current figures for the Bank of Canada to increase stimulus to the economy by making a cut in the overnight rate. One area to monitor is the Overnight Index Swap Futures which is traded on the Montreal Options Exchange. This is a tradable instrument and by way of its pricing, it provides an indication in real time of what the probability is for an increase or hold decision of the overnight rate at the next Bank of Canada meeting. Having watched this market for some time, the indications have remained at zero for some time now, and this seems to be a broadly shared sentiment by many of the other global central banks which we should take the time to observe.
Arguably the most important central bank for the interests of the global economy is the US Federal Reserve Bank, primarily due to the nature of the US dollar being the largest reserve currency in the world. The Federal Reserve have indicated that they dont foresee any further increases in 2019, as they are looking for the global economy to be firing on all cylinders to justify removing monetary policy stimulus by way of increasing the Federal Funds Rate from its current level of 2.5%. Why is the Federal Reserve Bank so important in respect of the global economy? We need to take some time to understand the impact of increasing interest rates in the US in respect of debt and currency held by emerging economies. A number of emerging economies rely on debt denominated in US dollars, so the increase of interest rates in the US can have the effect of increasing the cost of carry for this debt, and this can also be further compounded by the currency effect of an increase in the exchange rate, as a higher interest rate tends to have the effect of strengthen the home currency which can in turn make it harder for emerging economies to repay this debt based on a stronger US Dollar.
To look at other developed economies, they tend to be more reliant on their own central banks to provide guidance on investment decisions as any debt instruments tend to be denomination in their respective currencies. The Bank of England currently maintain the official bank rate at 0.75% after increasing from 0.5% in March 2018, while the European Central Bank (ECB) key interest rate is currently at 0.00% where it has remained since March 2016. There are many factors which are paring back growth prospects in Europe which are causing these low interest rates, but it is worth noting a significant divergence from the North American economies who have over the past couple of years found a greater opportunity to exert a level of tightening by way of increases to their overnight rate up to now.
In conclusion, it is worth keeping all these factors in mind when you are making investment decisions as individuals or collectively. For many households, the biggest investment they will make in their lifetime is real estate and its important that they are able to make an informed decision with all the tools that are available to them at the time.
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.