November 2017


This quarter’s Q & A is centered on most people’s biggest investment – their home.   Buying a home is one of the most significant financial decisions you’ll make in your lifetime.  For most people, the idea of owning their home outright, is still a distant thought.   Consequently, finding the proper financing is critical to ensure that you have your investment paid for as quickly as possible….all the while enjoying life as you complete this.   However, this balancing act is sometimes tough to manage.   There are many variables that can play into this – personal income fluctuations, moving to a different house, family dynamics, credit, market fluctuations and last but not least, interest rates.   In this quarter’s Q&A, we hope to answer some of the common questions that are imperative to understand around how interest rates affect your mortgage.

Q: What makes up a mortgage? 
A: A mortgage is a loan agreement between the purchaser and a lender, whereby the loan is secured by the property to be purchased.    The lenders can typically be banks, credit unions or independent mortgage lenders that cater specifically to the housing or commercial property market.   The mortgage is broken up into the principal amount borrowed and the interest charged on the money borrowed.   

Q: What is the difference between fixed rate and variable rate mortgages?
A:  A fixed rate mortgage has a specific rate of interest for the term of the mortgage.  A variable rate mortgage will fluctuate with the lending institutions prime rate.   For example, if a variable mortgage rate was prime + 0.50% and prime rate was currently at 3%, then your mortgage payments would be factored based on 3.5%.   If the prime rate changed to 3.25%, your mortgage rate will now be 3.75%.   Your payments will then be adjusted based on this.

Q: How do lenders determine their interest rates?
A:  Variable rate mortgages are determined by the fluctuation of the Bank of Canada’s overnight rate, the rate at which they lend to other financial institutions from day-to-day.   The overnight rate then affects the prime rate of each lending institution.   This is essentially the rate that they lend to their preferred (prime) clients.     
Fixed rate mortgages are influenced by the Government of Canada Bond yields.   These yields represent the cost of funds for financial institutions.   Bond yields are determined by a number of factors – inflation, currency and supply/demand of the bonds being the most common.   Fixed mortgage rates will always be higher than the equivalent Government of Canada Bond yield (the spread), as this represents the banks risk of lending the money to the borrower.

Q: What is the difference between a closed mortgage and open mortgage? 
A:  A closed mortgage offers better interest rates, but less flexibility to pay down the mortgage.  The lending institution will give you a better rate, knowing that there is an agreement to keep the loan for the entire term.   Whereas, an open mortgage gives you the ability to pay down the mortgage faster but usually with a higher interest rate than the equivalent term on closed rate mortgage.

Q: What are some bad habits that homeowners do when faced with rising interest rates?
A:  When faced with rising interest rates, home owners generally do a combination of 3 things.   First, they typically use more consumer credit.   This can often be unsecured loans or credit cards that have less than desirable interest rates.   
Secondly, they will consider reducing their retirement savings in order to be able to pay the higher mortgage payment.  This then hinders their plans to retire and/or save for their children’s education. 
Lastly, they will have to adjust their lifestyle.   They will accept having and doing less of what they enjoy in order to afford the same house with a higher mortgage payment.  

Q: What is interest rate laddering?
A:  Interest rate laddering is breaking up your mortgage into smaller pieces with different terms attached to each.  By breaking up the mortgage, only small portions renew at any given time.  It therefore provides the least risk to the household budget as your payments will only be marginally affected at the time of each renewal. 

Q: What mortgage strategy could help in a rising interest rate environment?
A:  First off, the best thing to know when interest rates are rising is knowing what type of mortgage you have!   Is it open? Closed? Fixed? Variable? The term? Etc.   If you have a mortgage broker that has helped you obtain the mortgage, know that they are there to help you between mortgage renewals as well.   Give them a shout!

If you have the option of renewing your mortgage, consider interest rate laddering as a way of protecting yourself from further rate increases.   Also, having the ability to pay down your mortgage principal faster allows you to save a considerable amount of interest in the event you have a lump sum to put against it.
Having a budget is also effective when dealing with higher interest rates.   If the budget allows it, accelerated payment towards the principal amount owed on your mortgage will save you considerable interest over the long-term.   

Also, to budget more effectively, consider fixed rates.   It’s not just about having the lowest payment.  Often times, the cost in having a higher payment (versus variable rate) is well worth paying if having the peace of mind in knowing what your payments will be.   This is especially true for family’s whose income may fluctuate from year-to-year.

Generally speaking, interest rates in Canada have decreased over the past 30+ years. However, with changes to government policy and strong economic conditions recently, some would say that we are now entering a new long-term cycle where interest rates will gradually work their way higher. If this is the case (I will reserve judgement at this time), then taking account of your mortgage terms will be of upmost importance. A lot of people consider their mortgage as something that they will just need to live and therefore it’s never top of mind until the renewal date. However, it’s really much more than that – it’s your gateway to owning your biggest investment. Now is more important than ever to understand the mechanics behind it. Otherwise, the effects of rising interest rates can creep into other areas of your life (credit, savings, lifestyle, etc.). Be proactive and take the time to ask the questions today! 

The information contained in this newsletter was obtained from sources which we believe to be reliable. However, this information is not guaranteed by National Bank Financial Inc., and may be incomplete.