Fixed mortgage rates heading down

ING Direct is dropping its 5-year fixed rate from 4.29% to 4.09% effective tonight. Firstline Mortgages have also reduced their rates earlier this morning.

I’m currently offering an ING Direct special with rates that are much lower than quoted on their website. Feel free to send me an email for all the details!

The reason for the decrease is bond yields have been steadily declining over the past 30 days. The 5-year Canada bond yield settled at 2.55% this afternoon. Given the standard margin, a deeply discounted 5-year fixed rate should be in the 3.90% to 3.95% range.

Click image to enlarge

If you are closing in the coming days and your lender’s rates have decreased, make sure that you don’t get left out in the cold and have them perform a look-back (if they don’t do so automatically). We provide this service to our clients free of charge so that they get the lowest rate on closing.

This disaster called collateral mortgage

Back in the fall, a handful of mortgage agents with an online presence, myself included, warned about how mortgages that are registered as collateral charge would significantly limit the options that are available to consumers. This was in response to TD Bank’s announcement that it would start registering all new mortgages as collateral loans starting in October instead of a standard charge.

For chrissakes make sure you read the fine print on these new collateral mortgages. If you go into them with your eyes shut, you’re just asking for trouble.

Would I buy one of these suckers? Not on your life! Do I look like a mouse to you?

Personal finance guru Gail Vaz-Oxlade, host of “Till Debt Do Us Part”, commenting on TD’s strategy to register new mortgages as collateral

This past weekend, Mortgage Broker News did an article about how some mortgage brokers are increasingly finding themselves in a position of turning clients away because of how the bank registered the mortgage.

First, let’s quickly recap what a collateral mortgage is. With a collateral charge, the lien is registered as a promissory note (essentially, a loan) that allows the lender to issue new funds to the homeowner should the need arise without having to refinance the mortgage. To accomplish this, the lender registers the mortgage at a higher value from the onset, up to 125% of the mortgage amount, in fact. If the consumer wants to take out equity sometime in the future, they will avoid administrative and legal charges.

On the surface, this sounds like a positive idea that would help the consumer if they ever need money by tapping into their equity at little to no cost. But when one digs deeper, we find that accessing any additional equity is not a sure thing at all. While the charge is registered as a loan under the pretense of providing the consumer with additional flexibility, the basic principles of equity lending still apply: if the client wants to withdraw additional equity, the property must appreciate in value to support the withdrawal.

If there’s insufficient equity, the client may not be able to withdraw the desired amount or even anything at all while now having a mortgage where the client is essentially “locked” with their current lender. With home sales moderating in 2010 and a similar trend is emerging for 2011, coupled with tighter mortgage regulations introduced in March and April, Canadians who purchased real estate at the peak of the market with little down may very well find themselves unable to withdraw additional equity.

The situation becomes even more complicated if personal circumstances change and the consumer requires additional funds but now doesn’t meet the qualifying criteria of the bank. Even if the consumer wants to obtain a second mortgage to take out equity or consolidate debt, they won’t be able to do so because the bank registered the lien of the first mortgage at a higher value.

If a consumer simply wants to transfer the mortgage at the end of the term to another lender, they will find themselves facing numerous fees. Lenders don’t accept collateral mortgages on assignment. With a standard document charge, if the client wants to move to another lender at the end of term, they can simply assign the mortgage to a new lender at little to no cost. But with collateral mortgages, the consumer would have to pay legal fees ($700 to $1,000 depending on the lawyer), full appraisal ($350), and discharge fees charged by their current lender ($200 to $300).

It remains to be seen if any other major lenders would start registering plain vanilla mortgages as collateral charge. While every business certainly wants to retain its existing client base and works hard to earn the trust of its customers so that it would get repeat business and referrals, there’s a stark difference between building a fence around your clients and shackling them to a steel post. Collateral mortgages do just that: not only do they tie the consumer to one particular lender but they also makes it a dreadful hassle to leave that lender in the future. While this kind of policy may be good for the bank, it’s a dangerous escalation in the industry especially when the practice is pitched to consumers by the lender with a positive spin without clearly disclosing the advantages and disadvantages.

Consumers must carefully research their options before accepting a commitment or pay dearly later.

BoC’s Mark Carney on CNBC this morning

Bank of Canada governor Mark Carney appeared on CNBC this morning from Helsinki. Here are some of the highlights of what he said about the state of the Canadian economy:

• April’s strong job numbers reported today were expected along with strong growth in Q1
• Growth is expected to slow down in Q2 as a result of Japan’s earthquake putting pressure on the supply chain
• 2 to 2.5% growth rate for the year
• There will be some spillover effect to the U.S.
• Canada will experience some flow-through as it remains heavily leveraged to the U.S.
• Canada’s economy has been boosted by a strong financial system that’s “firing on all cylinders” and strong demand for commodities from emerging markets
• High value of CDN$ is reducing the competitiveness of Canadian companies
• Developing economies are leading monetary tightening and not the G3; this is the new world
• Inflation is assessed differently in different parts of the world: for example, in Canada headline inflation tends to move towards core. In Europe and Asia inflation is assessed differently so there would always be some variance in how central banks deal with inflation
• A surcharge on global financial institutions is in the works

Murenbeeld’s latest economic monitor

Dr. Martin Murenbeeld of Dundee Wealth just released his latest monthly economic and market monitor. One thing that I really like about this issue is that it explains in detail some of the myths surrounding inflation and the most volatile (and political) components that are in the headlines these days: food and energy prices. Apparently today’s high food and energy prices are not an indicant of high inflation (or forthcoming hyper-inflation) but rather price adjustments that are the by-product of globalization (which we have all happily adopted).

Now you may be asking yourself what an average consumer in China or Brazil has to do with what your line of credit rate would be over the coming months or years. Here are some of the highlights to help you see the bigger picture:

On the Bank of Canada’s rate move

• The BoC will not raise rates over the summer and would likely wait until September 2011 and March 2012. A .25% increase is expected in both cases but the report notes that this projection is not set in stone
• Canadian consumer spending is slowing down
• Domestic credit growth remains flat
• The strong Canadian dollar isn’t showing signs of losing steam
• Inflation is expected to moderate in the coming months

On the Canadian dollar

• High commodity prices will continue to drive the CDN$ higher in the near term
• There is growing risk of a correction by mid-year if global growth slows down followed by another increase to potentially record highs against the USD

Rate moves from the Federal Reserve

• The Fed’s target rate will remain at 0 to .25% for the rest of the year and quite likely until March 2012. The Federal Reserve has no firm date in mind on when to raise rates
• Remaining stimulus measures are expected to end in 2012 with economic growth expected to be a bit better than 2% next year. Unemployment is expected to remain high and core inflation would be too low for the Fed to start tightening monetary policy
• Bond yields would likely increase following the commencement of QE2. However, the spike that some analysts are projecting might be somewhat exaggerated because the end of QE2 was well advertised and the markets have some time to adapt. Time will tell how this would play out

On the U.S. dollar

• USD is expected to fall further in the near term, especially if the European Central Bank raise rates again
• Sovereign debt problems in Europe have not been solved but merely postponed. This should help swing the advantage back in favour of the USD

On inflation in Canada and the U.S.

• Investor concerns about inflation are over-hyped
• Both the Federal Reserve and Bank of Canada have acted prudently to date
• Most of the recently reported U.S. and Canadian inflation is coming from higher energy prices and to a lesser extent higher food prices. Once these volatile factors are eliminated, the  core rate drops to 1.2% and 1.7% respectively, both figures being short of the Fed’s and BoC’s target band of 2% to 3%
• Despite the outcry from consumers, the current spike in food and energy prices is not the result of higher inflation but rather relative price adjustments which must exist for the economy to remain balanced

The primary cause of higher oil and food prices are:

• Increased demand from BRIC countries
• Continuing turmoil in the MENA (Middle East, North Africa)
• Domestic fuel subsidies in nations that are major producers
• Drought, weather, and flooding in several regions around the world resulted in tighter supply of main staples
• Dumb food supply management (with the U.S. topping the list for diverting corn from the food chain to the gas tank)

Simply put, higher food and energy prices are a byproduct of globalization. We can complain about it but we can’t really do much except adjust our consumption habits. People in Europe are more attuned to this technique as food and energy is expensive there all the time.

The report states that tightening monetary policy (increasing interest rates) at this point would be counter-productive and can send both the U.S. and Canadian economies back into a recession.

So is there really any inflation?

The answer is yes, but so far not here. In China, for instance, the rate of new money supply is expanding by 25% to 30% and real GDP is growing at 10%. The “excess” supply, which correlates well with inflation, shows that China is printing too much money and this led to higher prices across the board. While China’s central bank resorted to numerous tightening strategies over the past year to normalize prices such as increasing interest rates and requiring banks to hold larger capital reserves, the results haven’t been very effective. The excess money supply growth in China is twice the excess in the U.S. which lends credibility to the Fed’s position that inflation is currently not a problem in the U.S.

Murenbeeld also argues that the CPI itself is too restrictive to guide monetary policy because it doesn’t take an important component into account: asset price inflation. The financial meltdown we recently experienced was the result of an asset price inflation and not CPI inflation. As there’s no “asset inflation index” that can measure the risk that API poses to the economy, it’s difficult for central banks to identify asset bubbles in advance and take corrective measures.

Money supply problems is currently not a concern in the U.S. because of consumer de-leveraging, weak demand for credit, banks’ preference of holding excess reserves with the Fed, and corporations hoarding cash. As a result, the new money that’s being printed ends right back with the Federal Reserve and that’s why despite the Fed printing new money with its asset purchase program, that money doesn’t find it’s way into circulation.

Simply put…

It’s developing markets who are experiencing high inflation and not the U.S. or Canada. While there has been some spillover effect, the Federal Reserve and Bank of Canada should not tighten their policies because there are no signs that core inflation is rising rapidly. It’s developing markets that have to tighten their policies to combat inflation and this is already happening in several countries. (Note: Brazil, for example, currently has one of the world’s highest interest rates.)

This is not to say that inflation won’t become a problem in a few years. The growth of money supply in the world is clearly rising and inflation will be a problem at some point. But in the case of the U.S., higher inflation would actually boost the economy out of its slump. Once it becomes a “problem”, the Fed can pursue a calculated strategy on how to lower prices. But in the meanwhile, raising interest rates would be counter-productive given the slack in the economy and there are too many unknown variables.

There’s a lot more information in the report that will take too long to summarize. Click here to read the rest…

The end of QE2 would likely spell rising mortgage rates for Canadians

Federal Reserve chairman Ben Bernanke confirmed yesterday that the Fed’s asset purchase program (dubbed QE2) would end as planned in late June. He also noted that in light of weaker economic growth and unemployment remaining high, the Fed is in no rush to raise interest rates. Contrary to the Federal Reserve’s reassurance that it’s concerned about the low valuation of the U.S. dollar, it appears that they are content to let the dollar depreciate in an effort to stimulate economic growth and lower the rate of unemployment. Mission accomplished: the Financial Times reports that as of this afternoon, the dollar index slid to its lowest levels in 3 years.

Click on the image below to see the history of the USD over the past 3 years reflecting the financial meltdown of 2008, recovery of 2009 and 2010, and the second round of quantitative easing.

Source: FT.com

How does this announcement affect Canadian consumers?

• The Canadian dollar (as well as other currencies of countries that have already raised interest rates) will continue to rise in the short-term.
• Core inflation in Canada will very likely continue to increase in the coming months, putting pressure on the Bank of Canada to raise interest rates.
• High commodity prices will continue to push the CDN$ even higher. Canada is a major exporter of oil, minerals, potash, and grains.
• A high CDN$ is detrimental for domestic manufacturers who are exporting their goods to the U.S. Any rate increases by the BoC would push the CDN$ even higher and this will put more pressure on local producers.
• While consumers have been hit with higher inflation from rising food and oil prices, the problem will continue to get worse as producers and retailers pass on the costs. This process generally takes a few months to materialize.
• The negative outlook by S&P on U.S. debt will continue to weigh heavily on the USD until officials seriously address the enormous debt plaguing the U.S.

While many economists and analysts speculated that the BoC would not make a move before the Federal Reserve, it appears that higher inflation will leave the BoC with little choice even if it means that rate increases would push the CDN$ higher. Once QE2 is phased out in late June, it is projected that equities and commodities will cool off a bit. With the price of oil and other commodities weighing less on the CDN$, this may provide the BoC with additional flexibility to raise interest rates. Economists are now expecting a rate increase in July.

Lenders have already been reducing the decrement to prime in light of higher borrowing costs. With interest rates bound to increase, consumers who have an adjustable rate mortgage or a line of credit should brace for higher rates.

Why adjustable mortgage rates are heading up

Several lenders have quietly increased their adjustable mortgage rates over the past few weeks and it’s only a matter of time before others would follow. Financial institutions control adjustable rates in two ways:

1) The rates are based on the institution’s prime lending rate which is adjusted whenever the Bank of Canada increase or decrease its benchmark rate

2) Through the use of an increment or decrement to the institution’s prime rate

Adjustable/variable mortgage rates are typically priced based on a decrement (meaning prime minus). During the financial meltdown of late 2008 and early 2009, lenders moved swiftly to increase their adjustable rates despite the Bank of Canada curbing its benchmark rate. So while the institution’s prime rate fell in tandem with the Bank of Canada’s rate, lenders used the spread-to-prime to compensate for the spike in the cost of funds as a result of the crisis in the international credit markets.

Fast forward two years later. As a sense of normalcy returned to the financial markets, coupled with historically cheap borrowing costs, lenders have reverted to using a decrement to prime and consumers once again enjoy pre-meltdown rates. Current deeply discounted adjustable/variable mortgages, based on a 5-year term, are priced at prime – .75% to .80%, or 2.25% to 2.30% respectively. Compared with a deeply discounted 5-year fixed mortgage rate of approximately 4.09%, a savings of nearly 2% in the cost of borrowing is a pretty good deal for the right consumer.

With that said, bond traders are betting that the Bank of Canada will raise interest rates sooner than anticipated to curtail a sharper-than-expected increase in core inflation. It should be noted that the Bank of Canada’s core inflation target band is between 2% and 3%. February’s core inflation rate was .9%, the lowest rate since 1984, which led many economists and analysts to speculate that the Bank of Canada won’t be increasing rates at least until the fall of 2011 and perhaps even later. However, core inflation spiked to 1.7% in March, and this led to speculation that the Bank of Canada will increase interest rates much sooner than the fall. Some economists project that we could see an rate increase as early as July.

A weak U.S. dollar plays a big role in the Bank of Canada’s decision to raise rates. When the U.S. dollar index weakens, which was the Federal Reserve’s intention when they announced the second round of quantitative easing, the greenback depreciates against other leading currencies. As long as inflation remains anchored, the BoC would refrain from raising interest rates not to drive the value of the Canadian dollar even higher which can hurt domestic manufacturers and exporters shipping goods to the U.S.

However, once inflation starts to become a problem, in particular the core inflation rate which doesn’t factor volatile goods such as food and energy, there is more pressure on the BoC to engage in monetary tightening and raise interest rates. The Bank of Canada wants to send a message that they are being proactive and not reactive. In other words, they don’t want to wait until inflation goes above the target range as this would result in more aggressive increases which can negatively affect economic growth.

With the bond markets betting that the BoC would raise rates sooner than previously projected, bankers acceptance (BA) rates have moved upwards, which pushed up the cost of borrowing for financial institutions. BAs are short-term promissory notes (loans) issued by corporations and guaranteed by a major financial institution (these notes can also be issued by financial institutions). BAs have maturities ranging from 30 days to one year. Short-term notes are used by financial institutions as a source of funds for adjustable rate mortgages (ARMs). If BA rates have increased, the banks would raise their ARM rates to compensate.

Another reason why ARM rates are on the rise is because many consumers have been converting their adjustable/variable rate mortgages into a fixed rate term. Consumers who are worried about higher rates and wish to lock their rate can either convert with their current lender at no charge or discharge the mortgage and pay a nominal penalty. The amount of conversations is costing lenders money and this would ultimately trickle down to the consumer.

Last but not least, IFRS, which is a new set of accounting standards that are replacing the generally accepted accounting principles (GAAP), are heading into effect this year. Under IFRS, mortgages that are securitized must be reported on the institution’s balance sheet when calculating capital ratios. In order to free up their balance sheet, lenders pool mortgage loans together and sell them to investors in the form of mortgage-backed securities. This process is called securitization. As lenders would be required to account for these secured mortgages, they must set more money aside, which means incurring additional expenses. These expenses would be passed to the consumer in the form of higher mortgage rates.

You may have noticed that lenders who heavily rely on secularization have already increased the pricing of their mortgages. While Canada’s major banks would be required to meet the new standards later this year, some lenders are already factoring the additional costs. For example, the 5-year Canada bond yield has declined  by more than 20bp over the past two weeks. Based on standard margins, a deeply discounted 5-year fixed rate mortgage  should hover around the 3.95% to 4% range. But such mortgages are currently priced from 4.09% to 4.24% depending on the rate hold and even higher for the major banks (4.44%).

The bottom line for consumers: if you’re seeking an ARM and the closing is within 120 days, it’s highly advisable to lock the spread now. Otherwise, you may find yourself paying a higher rate.

It’s all about the yield

As Canada bond rates have retreated over the past 2 weeks, mortgage rates may decrease in the coming days. The yield on the 5-year benchmark bond eased from 2.81% to about 2.64%. If the trend continues, we can expect to see a rate decrease of 10 to 15bp. Current 5-year discounted rates are just above 4%. If we were to see a slight decrease, we may once again dip below the 4% range for quick-closing and high-ratio mortgages.

The news is not very rosy in the long run. With rising inflation already leading to consecutive tightening measures in places like China and India over just a few short months, the Eurozone posted the highest annual rate in more than 2 years, according to the Financial Times. What’s more concerning is the rise in core inflation, which strips out volatile items such as food and energy costs, increased unexpectedly to 1.5%, the highest level in two years (the bottom period of the recent financial meltdown). The European Central Bank (ECB) increased interest rates  earlier this month for the first time in three years. According to Statistics Canada, core inflation remains well anchored for the time being, which alleviates pressure from the Bank of Canada to move rates up.

With the second round of quantitative easing set to end in the U.S. at the end of June, inflation will become more problematic and as a result consumers should prepare to pay higher interest rates on their mortgage and lines of credit. As long as inflation remains in the Bank of Canada’s target band and the Canadian dollar remains well above parity against the U.S. dollar, the Bank of Canada will hesitate to move before the Federal Reserve. But once the Fed start raising its rates, consumers in Canada should be prepared for gradual increases starting in the late summer or early fall. In his March economic monitor, Dundee Wealth’s Dr. Martin Murenbeeld projects a 25bp increase in September and at least one additional increase before 2012.

Fixed mortgage rates would also increase once central banks start raising rates. We just don’t know to what extent. PIMCO’s Bill Gross, who manages the largest bond fund in the world, got out of U.S. government debt as he anticipates that demand will dry up once QE2 is phased out and the government would have to raise the yield significantly to make its bonds more palatable to investors. Suffice to say that yesterday’s outlook downgrade by S&P may have served as a rude awakening to American officials that the fiscal discipline must be addressed promptly, as even with a triple-A credit rating investors would demand a premium to hold additional debt.

Perhaps once the perfect storm gathers, this would be the ultimate nail in the coffin for Canada’s overpriced housing market.

Bank of Canada paper: borrowers who use Mortgage Brokers pay lower rates

Last month the Bank of Canada released a working paper about rate discounting in the mortgage market. The paper seeks to explain how banks price their mortgage rates and why some consumers get better rates than others especially when the mortgage is insured with CMHC or Genworth. Since mortgage default insurance protects the lender from loss when a borrower defaults, why then do banks still discriminate by providing better rates to some but not for others?

While it’s a lengthy read, here are some of the highlights.

The two primary factors that explain why some consumers get better rates than others are:

1. The profitability of each mortgage to the lender which includes the prospect of selling additional products and services, the borrower’s future renegotiation value (i.e. how likely would they shop for another mortgage upon renewal), and the borrower’s intention of prepaying the mortgage (banks aren’t enthusiastic about people who prepay their mortgage as it erodes their profits)

2. The consumer’s personal preferences of dealing with a particular institution as some consumers prefer to pay higher rates just for the privilege of working with a major bank or a particular branch, the amount of time it takes them to shop around (people who are high earners tend to have more respect for their time as spending time to properly shop for a mortgage takes time, the report refers to this as “search costs”), and their bargaining ability of directly negotiating better rates with lenders even if those rates aren’t published

The research team found that banks discriminate between consumers based on several factors including but not limited to age, loyalty, and financial constraints. Banks carefully evaluate “the current and future profitability of borrowers when deciding on rates”.

On the market structure

The mortgage market in Canada is dominated by six major banks: Bank of Montreal, Bank of Nova Scotia, National Bank, CIBC, Royal Bank, and TD Bank. Desjardines, which is the largest financial co-op in Canada, and Alberta’s ATB Financial are the two largest lenders after the “Big 6″. Collectively, these institutions control approximately 90% of the financial assets in the market.

The concentration of such a large proportion of assets held by only a few institutions is the result of legislative changes that took place in the early 90s that enabled banks to enter the trust business. Prior to these regulations taking effect, trust companies held a significant share of the mortgage market. In part, this was due to the fact that trust companies had different reserve requirements than the major banks.

Once the rules were amended to allow the banks to enter the trust business, they bought out most of the leading trust companies and thus began the monopolization of the mortgage market.

Up until the mid-90s, virtually no consumer received a discount on their mortgage rate through a bank. Bank clients paid posted rates and there was little to no variance in posted rates among the major banks. As a result of increasing competition from Mortgage Brokers, who within a few short years went from originating 5% of mortgage transactions to over 30%, and lenders such as ING Direct opening up shop in Canada and entering the residential mortgage market by offering fully discounted rates, some of the major banks experimented with various discounting strategies to retain business.

The big banks realized that providing every consumer with a low rate is not feasible. In contrast to lenders such as ING Direct, who offer every qualified consumer the same discounted rate, the banks embarked on a strategy of “discretionary pricing”. Instead of offering consumers the same discount, the banks found it more lucrative to discriminate between borrowers. To achieve this, the banks established higher posted rates and then “negotiated individual-specific discounts rather than lowering posted prices for everyone.” Combined with other factors such as age, loyalty, income, and market concentration, the report concludes that the more financially literate the consumer is, the higher the chances of receiving a discount over the institution’s posted rate.

On preventing new entrants

The objective of the selective pricing policy is two-fold:

• It allows the institution to sell consumers higher rates
• Discretionary pricing can theoretically act as strategic deterrence in preventing new competitors from entering the market place and serving the same customer segment

I assume an example of the latter would be lenders who want to compete purely on low rates will find it difficult to survive when banks can match their offer with comparable rates. As most consumers have multiple accounts with the same institution, they are more likely to remain there. The same logic can be applied to lenders that heavily rely on securitization to raise funds.

Who pays the highest rate?

The study concludes that the consumers who pay the highest rates are:

• Consumers who live in more concentrated markets
• Consumers who don’t take the time to shop around and familiarize themselves with what’s available in the market place
• Richer households in terms of loan size and home price (attributed to higher search costs)
• Financially constrained households (bank consumers specifically as the paper’s scope doesn’t apply to the alternative lending market as those mortgages are uninsured)
• Former renters and new homeowners who don’t have enough experience negotiating a mortgage contract (the report notes that first-time buyers, especially younger individuals who are more familiarized with technology and can shop around, may be more price-sensitive and thus receive a discount more easily)

Other factors to consider:

• The report finds that the larger the bank’s market share, the higher the rates it can charge to clients
• A consumer with a higher credit score is likely to pay lower rates than a consumer with a lower score even though both are sufficiently creditworthy for the bank. Remember, the mortgage in question is insured, so the risk of loss to the lender is low with both consumers. The study’s explanation of this policy is consumers with a higher credit score represent different profit opportunities for the bank. As banks discriminate based on future revenues (among other things that were already mentioned), a consumer with a higher score will likely receive a lower rate even if there is little to no variation in the risk of loss in contrast to an individual with a slightly lower credit score
  

On Mortgage Brokers in Canada

Unlike in the United States, Mortgage Brokers and Agents in Canada are heavily regulated in the province they conduct business and have fiduciary duty for clients. Although Mortgage Brokers are hired by the client, they are compensated, in most cases, by the lender underwriting the mortgage, which is a completely different pay model than the one in place in the U.S.

Fiduciary duty means the interests of the client must come first.

Screening

The report finds that banks routinely screen consumers based on their:

• Search costs: how much time does the client have to shop around for a mortgage?
• Valuation of services: does the client see any added value in working with the bank?
• Future profitability: does the client currently have other business with the bank? What is the prospect of getting additional revenue from the consumer in the future?

Negotiating a lower rate is costly for the bank and can reduce the commission earned by the bank’s staff. As such, banks carefully evaluate their clients so that rate discounting is minimized in cases where there is no need for it (i.e. consumers who don’t shop around, consumers who value working with the bank, consumers who wish to minimize their search costs, etc.)

Profitability for the bank

The profitability of a mortgage for the bank can be broken down into three components:

• Profit stemming directly from the mortgage contract
• Profits stemming from additional services such as bank accounts, investments, personal credit, etc.
• Profits stemming from future mortgage contracts

Profit from the current mortgage: consumers who prepay the mortgage (make payments in addition to their regular mortgage payment) reduce the revenue that the bank earns from the mortgage. This is especially true in the early life of the mortgage when interest allocation of each payment is greater than towards the end of the term.

Profit from additional services: the mortgage’s profitability also depends on the likelihood of the borrower obtaining other products and services from the same institution. The size of the down payment, for example, may be an indicator that the client would borrow from the same institution in the near future to finance other expenditures.

Profit from future mortgage contracts: lenders carefully examine the prospect of the client renewing his or her mortgage at the end of the term with the same institution. As very few consumers actually negotiate their renewal rate, the banks have an incentive to offer products that lock-in certain consumers. Clients who have larger loans and are likely to have a larger outstanding balance at the time of renewal as well as young consumers and first-time buyers are typically more profitable.

My personal observation regarding the last point: in recent years, we have seen major banks make some of their mortgages more restrictive in a blatant effort to lock-in the consumer. TD Bank, for example, registers all new mortgages as collateral charge, which makes it more difficult and expensive for the consumer to move to another lender at the time of renewal. Bank of Montreal introduced its “low-rate” fixed rate mortgage that merely matches the rate that Mortgage Brokers offer and yet is far more restrictive in terms of prepayment options and requires a bona-fide sale of the property to discharge.

The logic behind these increasingly restrictive mortgages can be summarized in one word: complacency.

First, very few consumers actually negotiate the renewal rate which is almost never the lender’s lowest discounted rate. According to data provided by CAAMP, 85% of consumers don’t negotiate their renewal terms and simply stick with the lender’s original offer. As rate discrimination is quite routine with renewal offers, consumers who don’t negotiate their rate end up paying something for nothing.

Second, despite the prepayment penalties, richer households will pay out the mortgage anyway. As such, locking affluent households for longer terms makes business sense.

Third, the average prepayment in Canada is very low.  A TD Economics report titled “Canadian Mortgage Market Primer” indicates that while most consumers have the ability to prepay 15% to 20% of their mortgage each year, the average prepayment in Canada is less than 1%. It’s clear that the majority of Canadians consumers don’t prepay their mortgage and this trend, coupled with consumers seeking increasingly larger mortgages, has allowed banks to eliminate or gradually reduce these prepayment facilities in exchange for a lower rate to compete for business and in some cases make the mortgage more restrictive altogether.

With prepayment penalties such as an interest rate differential, it’s clear that these policies are designed “to neutralize any financial incentive” to renegotiate a lower rate as the cost of breaking the current mortgage would offset any potential interest rate savings.

In terms of covering some of the closing costs as an incentive, the Bank of Canada paper found that very few institutions actually cover these expenses. The refund of the valuation report (appraisal) is rarely negotiable. Legal fees, home inspection, land registration fees, and insurance costs are not open for negotiation and remain the responsibility of the borrower. I’d just like to add that some lenders do cover the cost of an appraisal in some circumstances.

In closing

There is a lot more information in the report that simply can’t be summarized in about 1,500 words. But the message is clear: consumers who are complacent with their mortgage will pay a higher rate even if they are creditworthy for a major bank and the mortgage is insured. This principle applies to both affluent homeowners as well as middle class.

When financial institutions base their discounting decisions purely on credit risk, the variance in discounts is even greater.

The conclusions of this report can be summarized as:

• Higher income household pay less for their mortgage than lower and middle income households (richer households actually pay the highest rates based on loan size and home price)
• Borrowers who use Mortgage Brokers not only pay lower rates than borrowers who work directly with a financial institution but they also experience less rate discrimination based on household characteristics
• Banks discriminate between consumers based on age, net worth, loyalty, and future revenue for the bank from other services as well as the likelihood of the customer renegotiating the rate on renewal
• Individuals who take the time to examine their mortgage options get lower rates whereas an individual who prefers to work with a bank without shopping around is risking paying a higher rate
  
• Lenders that have the biggest market share can charge their customers higher rates
• Households that are “financially constricted” (too much debt) pay higher rates for the increased risk even if they are creditworthy for a major bank
• Homeowners who live in concentrated markets pay higher rates

Dundee Wealth’s Martin Murenbeeld on Canada’s inflation, housing, and consumer debt

Arguably one of the most comprehensive monthly reports put together, chief economist Dr. Martin Murenbeeld’s latest economic monitor sheds light on where he thinks Canada’s economy is heading in the coming months. Here are some of the highlights:

Inflation:

• Inflation expectation remains at slightly above 2%
• CPI hit 2.2% in February, well within the Bank of Canada’s target band. Core inflation, however, declined to .90%
• Inflation would likely increase over the coming months before moderating again
• Core inflation is forecast to reach 2% by year’s end
• With the current core inflation rate well below the Bank of Canada’s target and economic growth likely to moderate, there will be less pressure on the Bank of Canada to raise rates
• My addition: A strong Canadian dollar will also put pressure on the Bank of Canada not to raise rates so that the CDN$ will not appreciate further and create more problems for exporters

Interest rates:

• The Bank of Canada will likely refrain from additional interest rate increases until late summer or early fall
• 25bp incremental increases are possible in September and December 2011 and March 2012
• Bond yields in the U.S. may increase as a result of QE measures being phased out this summer (my addition: it’s likely there will be a spillover effect into Canada if that were to happen)
• The Canadian dollar will continue to remain above parity until year’s end and as long as oil prices remain high. It may increase further in the short term before moderating again to more normal levels. As discussed above, this will put pressure on the Bank of Canada to leave rates where they are over the next 4 to 6 months

Consumer credit:

• While residential mortgage credit continues to show relatively strong growth, it would moderate over the spring and summer as a result of tighter mortgage rules. As of December 2010, over $1 trillion of residential mortgage debt remains outstanding, an increase of nearly 30% since January 2007. Short-term business credit remained relatively flat throughout 2010
• Consumer credit growth has decreased for much of 2010
• The U.S. and Canadian debt-to-income ratio remains about the same at just under 150%. However, while U.S. consumers have been heavily de-leveraging themselves since 2009, Canadian consumers continued to sink deeper into debt
• It is possible that consumer credit would continue to decline this year as a result of high debt levels
• Job creation remained strong but the unemployment rate is still relatively high

Housing:

• Over the past year, housing prices increased by a modest 1.9%. Prices increased from December to January by .2%
• Housing starts saw a small increase in January mainly the result of condo development in Ontario. This sector is expected to slow down as demand rescinds and tighter mortgage regulations go into full effect
• My addition: The tightening of mortgage rules started in March with CMHC removing support for 35-year amortizations. As a result, many lenders stopped offering 35-year amortizations even for conventional mortgages. The second round of tightening will come later this month when CMHC would stop backing HELOCs

The rest of the report can be downloaded directly from Dundee Wealth Economics.

ICICI Bank now offering conventional mortgages

Just a quick note that ICICI Bank, which is one of India’s largest banks, is now offering conventional mortgages through Mortgage Brokers. Their fully discounted rates are quite competitive with Canada’s major banks. They offer a variety of mortgage terms, flexible repayment options, and they work with both CMHC and Genworth for insured mortgages.

One area where ICICI stands out is that they offer free refinances. They will even arrange to come to your home to sign all the papers.

While most lenders cover the valuation and legal fees on a transfer where the mortgage amount remains the same, virtually no one offers free valuation and legal fees on a refinance. These costs are typically the responsibility of the consumer.

Homeowners who don’t want to pay these fees with traditional lenders when refinancing now have the option of working with a well-capitalized bank that will pay these charges to earn their business.

If you would like to know their rates, please don’t hesitate to contact me as the our rates with them are lower than what’s listed on their website.