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decoding the mortgage market

Houses in downtown Toronto March 27 2014.Fred Lum/The Globe and Mail

It has become a lot tougher to make sense of mortgage rates in the past few weeks.

With Canada in the midst of economic misfortune (the decimation of its oil industry), inflation expectations are falling. That usually leads to a drop in mortgage rates. But in today's bizarro world, the usual is not happening.

What we're actually seeing is banks moving rates up. In the past week alone, advertised mortgage rates have jumped 0.10 to 0.15 percentage points at our Big 6 banks. That has surprised and confused not only borrowers, but many mortgage professionals.

What's behind it

If you're trying to make sense of it all, the first thing to understand is why banks hiked rates in the first place. It's a combination of six things, say lenders:

1. Rising short-term rates;

2. Investors demanding higher yields from mortgage lenders;

3. Provision for higher potential mortgage losses;

4. Preparation for potentially falling rates (which hurts bank margins);

5. Less demand from mortgage investors;

6. Preparation for upcoming regulatory changes, which will make lending more expensive.

What happens next

The reasons above will likely keep variable-rate discounts skimpy for the foreseeable future, at least at the major banks.

For fixed rates it's a different story. Unlike variable rates, which are funded by short-term debt and deposits, the cost of fixed-rate mortgages is tied to the bond market. That's good news for mortgage shoppers because bond yields are near all-time lows.

For now, cheaper funds in the bond market are offsetting the six factors above. That's why we're seeing lenders trim fixed rates as we speak. This doesn't rule out higher rates down the road, but it does mean that you don't have to panic about locking in.

Where the bargains are

Last September you could walk into any bank and get prime minus 0.55 per cent on a variable-rate mortgage. Nowadays, you'd be lucky to get prime minus 0.25 per cent.

If there's one piece of advice I can offer you, it is this: Ignore variable rates worse than prime minus 0.50 per cent. They're just not worth it. Variable-rate lovers are better off in a one-, two- and three-year rate. (This assumes you're getting a new mortgage. If you already have a great variable rate, like prime minus 0.75 per cent, hold on to it like a winning Powerball ticket.)

Choosing a variable at prime minus 0.50 per cent (i.e., 2.20 per cent) or worse means you'll likely pay more, even if the Bank of Canada cuts its key lending rate to zero. The reason: Shorter terms have much better rates and banks probably won't pass along more than 60 per cent of any Bank of Canada rate cut – assuming the past two cuts are a guide.

Knowing this, it's easy to model how different mortgage terms perform in that scenario. Let's assume, for example, that the Bank of Canada responds to the current economic risks by slashing its overnight rate by one-half percentage point. Then, two years later, the economy perks up and rates jump 1.5 points.

Mathematically speaking, which term wins in that situation?

Given a well-qualified borrower, a 25-year amortization and current mortgage rates, the answer is a one-year fixed.

The one-year edge

One year rates should perform best in this environment for four reasons:

1. At 1.99 per cent, give or take, they're the cheapest rate in the market (and equivalent to prime minus 0.71 per cent);

2. If rates fall as many expect, you'll potentially renew even lower in eight or nine months (I say eight or nine months because most lenders let you hold a new rate for 90-120 days);

3. Thanks to the economic cataclysm occurring in commodities, your renewal risk is limited – i.e., there's very little chance of significant rate increases in eight to nine months;

4. A one-year term provides maximum flexibility because you can renew into any other term and any other mortgage type, depending on the rates and your personal circumstances at the time.

Things to watch out for

Mortgages are like gloves: One does not fit all. If you do opt for a one-year term, keep three things in mind:

1. Your lender may not offer you a great deal on renewal, forcing you to change lenders;

2. If you're switching lenders, find one that covers your legal, appraisal and title insurance fees. Note: That's not usually possible if you have a secured line of credit;

3. Unless you need to borrow more within 12 months, avoid "collateral charge" mortgages, which make it more expensive to switch lenders at renewal.

Short-term mortgages are best suited to those with good credit, a reasonable debt load and stable, provable income.

By contrast, you may need the security of a longer fixed rate, or want a rate you can set and forget for four to five years (renewing does take three or four hours of your life, after all). Or maybe you simply can't qualify for a one-year rate, since lenders make you prove you can afford payments based on the posted five-year rate (currently 4.64 per cent).

In my case, I make regular sacrifices to the mortgage gods, thanking them for the prime minus 0.80 per cent variable my wife and I got last September. Sadly, they don't make those any more, but one-year terms are the next best thing.

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

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