Real Insight: The Long and Short of Interest Rates

John in Real Insight, Money, HomeBuying

Ed note.  Real Insight is a periodic feature decoding some of the many mysteries surrounding HomeBuying.

Earlier this month, I came across a Globe and Mail article on interest rates which concluded with these words of advice from CIBC senior economist Benjamin Tal:

[HomeBuyers]…should be aware that as the spread between long- and short-term rates moves closer together, the difference between fixed and variable mortgages is probably negligible.

Now, I don’t know about you, but most of the HomeBuyers I know don’t have the time or motivation to read through old Economics 101 textbooks in order to really grasp what Mr. Tal is getting at.  So, leaving aside some of the finer points in Mr. Tal’s overall assessment of the Canadian economy, I thought it worthwhile to discuss the point raised above as it pertains directly to HomeBuyers.

One of the common misconceptions that HomeBuyers have about interest rates is that all rates move in unison: that is, all interest rates are either rising, falling or staying constant.    The reality is that interest rates don’t have to move in the same direction and in fact do move in different directions at times.  If you want to see this in action, consider the fact that interest rates for variable rate mortgages have been constant for the past few months while those for 5-year fixed rate mortgages rose almost a full percentage point over the same period.

How does this work?

Two key interest rates influence what HomeBuyers end up spending on their mortgage. 

The interest rate for variable rate mortgages (the short-term rate) is directly linked to the interest rate set by our central bank, the Bank of Canada.  This means that when the Bank of Canada increases rates by half a percentage point, your variable rate mortgage will also increase by the same amount.

5-year fixed rate mortgages are a bit trickier.  The interest rate for these mortgages is based on current interest rates in the bond market (the long-term rate), which the Bank of Canada influences but ultimately has little control over.  A bond is just a fancy name for a particular type of loan.  What makes bonds interesting is that they are in fact loans that can be bought and sold—much in the way stocks are bought and sold.  This means that the interest rates in the market fluctuate depending on how many people are buying or selling.

So the next question is—how does the bond market influence your mortgage rate?  Consider this simplified example.  Suppose you need a $200,000 5-year fixed rate mortgage, but on the day you walk into your bank, they don’t actually have $200,000 to lend you.  Instead of turning you away, your bank is going to go out to the bond market to borrow this money and then lend it to you.  Now, remember that we are simplifying things—multiply these transactions many times over and you get an idea of what banks are doing day-to-day.  The bottom line is that because your bank is going to pay current interest rates in the bond market on the money it is lending you, you will be charged this rate plus a slight premium on top.

This insight can help us understand what’s been happening with interest rates recently.  The interest rate on variable mortgages has not changed because the Bank of Canada has not increased interest rates.  However, the Bank of Canada's recent suggestion that it may raise interest rates caused a bit of a stir in the bond market. The interest rates in the bond market (and hence fixed rate mortgages) rose in anticipation of this rise in short-term interest rates.

Why does this matter to you?

Many HomeBuyers prefer to lock-in a 5-year fixed rate mortgage because it protects them from future increases in interest rates.  HomeBuyers usually pay for this additional security in the form of a slightly higher interest rate than they would have paid with a variable rate mortgage.   For example, if the interest rate for a variable rate mortgage is 5.25% and the interest rate for a 5-year fixed rate mortgage is 6.25%, HomeBuyers who choose a fixed rate mortgage are paying a 1% higher interest rate for the additional security.   So far so good, but what mortgage to choose when rates are expected to rise?

Instead of merely reacting to the words that all HomeBuyers dread—rising interest rates—what we need to do is notice where long- and short-term interest rates are going relative to each other.

Recently, long-term interest rates were on the rise while short-term interest rates remained constant.  This means that the spread, or the difference between the two rates, also increased.  A higher spread means that HomeBuyers are paying a higher premium for the security of a fixed rate mortgage relative to HomeBuyers opting for a variable rate mortgage.  Now back to Mr. Tal, who reminds us that “as the spread between long- and short-term rates moves closer together, the difference between fixed and variable mortgages is probably negligible.”  This means that the closer the two rates get, the less of a premium HomeBuyers pay for the security of a fixed rate mortgage.

Now that you know to keep your eye on different interest rates rather than ‘the rate’, be sure to discuss the particularities of your own situation with your mortgage specialist.  In my next post, I will detail how long- and short-term interest rate changes may affect you in a real life scenario.

John Pasalis is a sales associate with Prudential Properties Plus in Toronto and a founder of Realosophy.

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