Why the recent bump in mortgage rates will be more painful than you think

RE market

Interest in mortgage rates spiked this week after Toronto-Dominion Bank boosted its posted five-year fixed rate by 45 basis points (bps). The aggressive move undoubtedly unnerved many homeowners, who were left wondering whether they could afford higher rates.

Most other big banks have been following suit with smaller hikes of their own, all but ensuring that Canadians will be facing a more strenuous mortgage stress test next week. The Bank of Montreal raised its five-year fixed rate by five bps on Thursday, and with this, the mortgage qualifying rate (MQR) will most likely rise to 5.34 per cent next week. But that depends on what Bank of Nova Scotia does – it’s the last major bank yet to announce any changes to its mortgage rates. The MQR is currently 5.14 per cent.

A 20-bps hike to the benchmark five-year fixed rate would mean a 1.5-per-cent reduction in home-buying power, give or take. (There are 100 bps in one percentage point.)

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Despite the flurry of headlines, the actual fixed rates people are paying have only risen about 10 bps in the past 10 days. So, how big of a deal is this?

The true impact of this week’s rate changes isn’t the modest uptick in borrowing costs. It’s the unpleasant effects that borrowers will feel later.

First, some context

We’ve got skidding home prices, stringent new mortgage rules, escalating interest rates and record-high debt.

With that backdrop, you better believe that every time mortgage rates rise materially from here on in, we will witness this same reaction: people fretting that this could be the rate hike that busts their budgets or initiates a housing meltdown.

Well, we can all keep waiting because this week’s hikes do not spell doom for the market. So far, the average bank has raised its five-year posted rate just 25 bps, something that’s happened 21 times this millennium alone. And like I said, actual market rates are up just a tick, while variable rates are falling.

Where it really hurts

Here’s the interesting thing about TD’s 45-basis-point hike last week: It didn’t raise actual rates anywhere near that much. This effectively means its discounts from posted rates have increased.

While that might sound good to the uninitiated, it means that interest-rate differential (IRD) charges (a.k.a. penalties) may surge for new fixed-rate borrowers who exit their mortgage early. That’s because big-bank penalty formulas are geared so that bigger discounts from their artificial posted rates result in a wider gap between the rate you pay and the rate at which they claim to be able to lend, at the time you break your mortgage.

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Widening that gap by 45 bps, as TD did, could boost a penalty as much as $1,700 when breaking the average-sized fixed mortgage before maturity, depending on rates at the time. The average existing mortgage is about $200,000 or so.

Renewers feel it, too

The federal Department of Finance bestowed a gift on banks that’s about to keep on giving.

Canada’s Big Six banks now have the power to determine the minimum interest rate (or MQR) used to qualify more than four out of five residential mortgages in this country.

The government uses a convoluted formula to derive the MQR. Instead of simply making you prove you can afford a rate that’s two percentage points higher, for example, the government makes you prove you can afford payments based on the MQR. This rate is based on the “mode” average of the Big Six banks’ five-year posted rates, with complex tie-breaker rules if there are multiple modes. Sorry if I just lost you there.

Apart from being as clear as pea soup, this method empowers big banks to make qualification tougher than necessary. This makes it all the harder for more than one in 10 renewing borrowers to pass the stress test and switch lenders to get a better rate.

New borrowers also feel it

Even if you’re a more competitive lender with lower rates – for example, a credit union or mortgage-finance company – you most often must use the MQR set by the big banks to underwrite your borrowers.

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If you’re a bank competitor who wants to offer lower rates to help more people qualify, this reduces that incentive. So not only do borrowers get approved for less than they can afford, they pay more interest.

The answer

There’s no legitimate overarching reason to give just six banks licence to determine how every other prime lender and borrower does business, not when the same end can be achieved in a fairer way.

Ottawa would have done a far greater service to Canadians by pegging the MQR at a simple 200 bps above the lender’s five-year fixed rate. This method is simple to understand, it confirms people can handle much higher rates, and it’s good for competition and your wallet.

And it doesn’t confuse the hell out of people.

Robert McLister is a mortgage planner at intelliMortgage and founder of RateSpy.com. You can follow him on Twitter at @RateSpy

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