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Mortgage Rates at 8% ? Maybe. One Bank Seems to Think So…

Monday, January 26th, 2009

In the past two weeks, we have seen rates drop from around 4.99% on a 5 year mortgage to 4.29% – a move of over half a percent. For many lenders, the move was even more dramatic as they started out in the low 5’s and ended up at 4.49%. This is the largest rate drop in this short a period of time that I have seen in the past few years, but amongst all of it, one bank is offering a term deposit rate of 8% on a 5 year term. Eight percent! So how can they do this unless they clearly think rates are going to be going back up above eight percent? Let’s look at their offer, and see if we can infer where they suggest rates may be headed on mortgages at the same time.

TD Bank’s Offer of “5 Year Stepper GIC”

Year 1 – 1.80%
Year 2 – 3.50%
Year 3 – 4.00%
Year 4 – 4.50%
Year 5 – 8.00%

5 Year Average = 4.36% (Annual Interest)

5 Year Current Mortgage Rates = 4.54% through TD Bank (converted from 4.49% semi-Annual Interest to annual interest for comparability purposes)

NOTE: Term deposit is FULLY REDEEMABLE each year on the anniversary date.

So apparently, the bank is giving you 4.36% and only charging 4.54% ? This means that on $1,000,000 of business they are only making $1,800 per year? People often say that banking is a volume business, but even if they do $100,000,000 of business they still only make $180,000 of profit, and that is before expenses. Clearly, something more is going on here. The bank MUST be making money somewhere else, or, pardon the pun, banking on a higher return somewhere down the line.

ANOTHER SOLUTION?

Another alternative is that the bank is hoping that people do not hold their term deposits for 5 years, and that rates will begin to rise between now and then (in the early years of the term). For example, if, one year from now, rates on term deposits and mortgages are in the 6% range, and the client is in the second year of this term (3.50%) they may be inclined to cash out on the anniversary date and re-lock in at the new higher rates. Having been in banking and finance for 9 years now, I have seen this type of product before where banks hope that clients will not hold for the full 5 years. However, just like most situations, even if the rates rise this is a win-win situation for the bank.

Why? Because their yield, even if the client holds it for all 5 years, is still only 4.54%. So here is how the bank profits and an explanation of the only situation they may lose:

1. If rates RISE, clients may cash out and get into the new higher rates. Bank doesn’t pay 8% in year 5, and gets the money for the early years at 1.50% – 3.50%. Bank wins.

2. If rates RISE, but client does NOT cash out, the bank only pays the average over 5 years of 4.54% annually. If rates have risen, this is comparatively low. Bank wins.

3. If rates FALL, clients will stay in, earning 4.54% over 5 years and 8% in year 5. Some clients will still withdraw funds due to life situations, but overall, the bank loses in this scenario.

A further note: interest rates are near (or at in some cases) all time historical lows. In other words, there is a lot of room upwards, but not a lot of room downwards in interest rates. The general consensus amongst industry professionals is that rates will remain low in early 2009 to stimulate a sagging economy, but will rise (possibly dramatically) in late 2009 and for a prolonged period of time. Given this information, it seems very very likely, that either option 1 or option 2 (rates rising) will come into effect, and the bank will win again. Some things never change, do they?

Bottom line: I think this is a brilliant marketing strategy by TD Bank. They are utilizing their treasury, and a unique interest rate environment, to profit from potential rate increases which everyone seems to think are just around the corner. With such a large likelihood that rates will rise, this is a well informed bet by TD combined with a marketing gimmick that is sure to bring them additional business. However, the savvy investor will likely want to look elsewhere as being on the losing end of a heavily favoured bank bet is never a great investment.

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