Mortgage Basics: Interest Rate
Interest rates, where to start! This is often the center of a borrowers focus and in today's lending environment one of the hardest elements to navigate. The interest rate that you get on a mortgage today is dependent on so many factors, your credit score, the amount of equity you have in the home, whether it is default insured (that's a whole post on it's own!), and the intended use of the home. In this blog piece I am going to focus on defining the various types of rate that come into play.
Contract Rate: This is the rate that defines your payments and how much interest you will pay over the term of your mortgage. The rate will vary depending on the length of term you take and all of the factors that I mentioned above. Within the contract rate there is also the choice to take a fixed rate or a variable rate.
Fixed Rate: A fixed rate is just that, fixed for the entire length of your term. It will not change. The majority of Canadians choose a fixed rate because they like the security of knowing that their payments will not change during their term. This is a good choice to make for anyone who is risk averse. Fixed rates in Canada are influenced by Canadian Government bond yields because they are a key factor in determining a financial institutions cost of funds.
Variable Rate: A variable rate is one that can change during the term of the mortgage and is quoted as a formula of the prime lending rate plus or minus a fixed amount. For example prime minus 0.5%, so the discount/premium remains fixed during the term but if the prime lending rate changes then your rate will change. If, in the example above, the prime lending rate was 3.2% when your term started your rate would be 2.7% (3.2-0.5), but if the prime lending rate rises to 3.45% then your new rate would be 2.95%. This would also mean that your payment would change.
How is the prime lending rate determined? Here in Canada it is based on the Bank of Canada's (BoC) key overnight rate or target rate. The BoC meets multiple times per year to take the temperature of the economy and determine whether that target rate needs to be moved up or down. In an economic slump they would drop the rate to trigger borrowing, as the economy rebounds they move it up. At the time of writing this we are in a rising interest rate environment. Variable rates tend to always be lower than fixed rates of the same term, however there is an element of risk associated in knowing that your rate and payment can change during the term.
Benchmark/Qualifying Rate: If you have a high ratio insured mortgage (putting less than 20% down) then you need to qualify for a mortgage at the qualifying rate. At the time of writing this the qualifying rate is 4.89%. This is what is called a 'stress test' and ensures that should rates rise dramatically during your term you will be able to weather that increase at renewal and still afford your mortgage. The qualifying rate is determined by the BoC and is calculated as the mode of the big six banks posted five year fixed mortgage rate.
Posted Rate vs Discounted Rate: The term 'posted rate' is a carry over from when the bank was the only place to get a mortgage and they would post their rates up for all to see. Then the mortgage broker channel and monoline (non-bank) lenders were born and they entered the market with lower rates than the banks. In order to compete the banks began 'discounting' their posted rates. The banks have stuck with this antiquated posted and discounted rate system ever since. Monoline lenders do not have posted rates, they have their rates, take em or leave em. While the banks still have posted rates they are generally only used by the BoC for determining the qualifying rate and by the banks when they calculate your penalty.
You see what many people don't realize is that as you negotiate your rate down when dealing with a bank lender you are also increasing your potential penalty. This is because they use that 'discount' that they gave you off of posted to calculate the penalty you will pay when breaking a fixed term mortgage early. And believe it or not that 'discount' can potentially cost you thousands of dollars! Because monoline lenders do not have posted rates no discount is taken into account in their penalty calculations.
Well I think that about covers the various rates that you will encounter when seeking mortgage financing. Remember I am always happy to answer any questions that you have, I am only an email or a phone call away!
