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.

This is a very common question, and one that I have addressed before, but have taken three calls from all around North America this week.

Usually the question runs like this: “I would like a fixed mortgage, but I want it to be open. What is your best rate?”

This is a confusion of two common terms. Let me first address the different types of mortgages. For simplicity sake, there are four common types of mortgages, that all combine with one another. They are:

1. Fixed Mortgage
2. Variable Mortgage
3. Open Mortgage
4. Closed Mortgage

Let’s address each in turn. NOTE: these terms are being described as they relate to the CANADIAN mortgage market, not the US:

FIXED MORTGAGES:

A fixed mortgage is one where the rate is fixed for the entire term of the mortgage. For example, if you have a 35 year amortization (pay it off over 35 years) but a 5 year term, that means that you will have a fixed rate for 5 years, with a fixed payment for 5 years, and a fixed rate for 5 years. The mortgage rate and payment are FIXED for the term. Terms vary from 1 to 10 years (a couple lenders do longer) and the average term people choose is 5 years (which is also the length of time over which the banks compete most aggressively).

VARIABLE MORTGAGES:

A variable mortgage is one where the rate varies with some other rate. The most common rate that the mortgage moves with is the “Prime Rate.” Traditionally, the Band of Canada (BOC) sets their prime rate, and the banks then follow and set theirs at the same rate. The prime rate is the rate that preferred borrowers with clean credit and good income can receive. There is no law that says that the banks must follow what the BOC does, and in the current market in Sept / Oct 2008 the banks have chosen on a couple of occasions to NOT follow the BOC right away or to follow them precisely. A variable rate mortgage usually results in a payment that also varies with prime rate (often making budgeting difficult), and a rate that varies according to the market. While most variable rate mortgages are convertible into a fixed rate at any point in time, the rate you can convert at is “usually” quite high relative to what you would get on the open market.

OPEN MORTGAGES

An Open Mortgage is a mortgage that has no pre-payment penalty. With most mortgages in Canada, if you pay out the mortgage before the end of the term, you will pay an interest penalty (usually equal to 3 months interest payments but there are alternative penalty calculation methods). Open mortgages do not face the interest pre-payment penalties that other mortgages face.

CLOSED MORTGAGES

With a Closed Mortgage, you WILL face an interest penalty to pay it out prior to the end of the term. For example, if you have a 5 year term, and you pay off the mortgage in 2 years (whether it is due to a sale of the home, lump sum of cash, or any other manner) you will face an interest penalty usually equal to 3 months of interest. There are other methods of determining pre-payment penalties, but the 3 month interest is the most common unless rates have fallen dramatically during the term of the mortgage.

So why would anyone take a closed mortgage? Answer: Because they (typically) have far, far better rates when you commit to a set term. Also, that is the industry standard in Canada.

So, based on the info above, you can combine the terms (no more than 2 per combination) to get a feel for what is available in the Canadian market place.

You could have:

Fixed Closed Mortgage
Fixed Open Mortgage
Variable Closed Mortgage
Variable Open Mortgage

You may wonder, “Why doesn’t EVERYONE get a fixed OPEN mortgage?” As that seems like the best combination of security (fixed rate) and no penalty (open). The answer is: the rates are far higher. If the banks are going to go through all the effort and time to do a mortgage for you, and commit the money, they want to know they are going to get that stream of income for the length of the term. When you purchase a term deposit fromt he same bank for, say, 2 years, you expect to get 2 years interest, not get 1 year and have the bank cancel after 12 months because they can pay less to someone else! What’s fair is fair. If you commit to a term, expect a penalty.

Often people say to me, “yes, but what rates are available for each product?” I’ll show you my best rates currently for each product below:

5.35% – Fixed Closed Mortgage (based on a 5 year term)
8.10% – Fixed Open Mortgage
5.25% – Variable Closed Mortgage (Based on Prime rate plus 1%)
5.25% – Variable Open Mortgage (Based on Prime rate plus 1%)

Clearly, taking a Fixed Open Mortgage is the best in terms of flexibility, but the rate is far higher and thus payments of a huge obstacle. Also, the difference between a fixed and variable rate is not much. In fact, you can get a 0.10% lower rate by taking a variable rate! This might sound like a good deal, but how much is your peace of mind worth? If rates shoot up by 1% due to an economic crisis, your payment will jump substantially (by 1%) and this will result in a much much higher payment.

How much higher?

Assuming a $300,000 mortgage, the savings of taking a variable rate mortgage (0.10% savings) will result in a savings of $22.14 per month. Assuming rates stay steady for ALL FIVE YEARS you will save $1,328.40 by taking a variable rate mortgage. Not bad, right?

Wrong. If you assume that prime rate moves up by 1% due to a shocking economic crisis (much like we are facing now) your payment would jump from $22.14 lower to $203.85 HIGHER simply due to factors beyond your control. This, by the way, assuming it happens 2 years into the mortgage, will result in 3 years of higher payments equaling $7,338,60 more. So you would be out by THOUSANDS of dollars just for trying to save $22.14 a month.

My advice: In this market, take a fixed rate. Enjoy the fixed payments, and sleep easy at night knowing your payment will be the same this month as it will next month for the entire term.

With respect to Open vs. Closed mortgages, unless you are buying with the intent of flipping it off (and NOT buying another property) ignore this. Take a fixed closed mortgage, and you’ll be glad you did.

If you are considering buying an investment property which you may quickly sell, THEN, and only then, do I recommend an open term.

There has been a lot of coverage on the news recently about “Main Street” and “Wall Street” and what each means, but I’ve never heard them define what those terms mean. In today’s post we’ll cover this little tidbit of info and explain how the media is using the term.

“WALL STREET” is referring to the investors, investment houses, and investment banks that put money (often their clients’ money) into certain invesments. When you hear a news reporter say, “there was a lot of pain felt on Wall Street today,” they are referring to the major investment banks and investment houses suffering losses. The name “Wall Street” comes from many historical references, but it is the location of the NYSE (New York Stock Exchange) as well as the name given to the financial district in New York.

“MAIN STREET” is referring to all the citizens of the US. When you hear a news report say, “the pain felt on Wall Street might not filter down to Main Street for quite a while yet,” you are hearing them say that the pain felt by the investment banks might not be felt by you and me for a while yet.

So essentially, Wall Street is the investment banks and financial companies, whereas Main Street is the “everyman” in the United States.

In the context of the US Sub Prime meltdown that is still occuring, these terms are often used on the news with little or no explanation of where they come from.

Now you know!

So I haven’t posted in over a week, and it’s been because i’ve had my head down working like a dog while reeling from the effects of the last week’s meltdown in the financial sector. Finally, after an up and down week, and Fed in the US approved the bailout. You would think that this is great news for the real estate industry, right?

I’m not so sure. What this plan effectively did is nationalize a private problem. There is a saying somewhere that when profits are made they are private, but when losses are taken, they’re public. I know that isn’t a direct quote, but it is close enough to get the gist of it. It is also very very true. So long as the market continued along unabated, with profits being made, private investors got to keep all their profits, spend it as they wished, and not have to pay anything other than taxes. When the problems set in, and the investors all stood to lose a lot of money, enter the Fed and a massive public bailout that effectively increases the national debt that took them over 100 years to build by 10% in a single blow. I don’t like the precedent that this sets, and hope that the bailout doesn’t totally bail out all the lenders and institutions that acted irresponsibly over the past 8 years. That said, I also don’t want the market to go into a tailspin and melt down.

A lot of the price appreciation we have seen in Vancouver Real Estate in the past few years is driven by the market being very desirable to live in, own in, and even rent in. As a result, prices have (and should have) risen. However, as someone on the front lines of mortgages and real estate, I DO think that prices have gotten ahead of value, and we are in for a correction.

Unlike the United States market, however, I do NOT think that prices will come crashing down around us. Our lenders up in Canada, (yes, even those based out of the US) were more conservative than there brethren in the US and required a borrower to have more than a pulse and sufficient body temperature to warrant getting approved for a mortgage.

Did we have true sub-prime lending in Canada? Yes, but only at a few lenders, and always at no more than 95% financing with most preferring to remain at less than 80% financing even on rock-solid properties. The US actually had lenders lending (in some rare cases) up to 125% of the purchase price with the hopes that property prices would continue to rise and put the clients back “into the black” in a few short years. While this strategy allowed clients to roll all their other debts into their mortgage as well, it only worked while prices continued their meteoric rise upwards. When they started to roll back, that was the end for those lenders (and insurers who insured the mortgages).

So where are we going from here? I met with a few other brokers over the weekend and we chatted about where the market is as well as some of the large pull backs in prices we have seen recently. Most of us agree that prices are likely still going to continue downwards for a while, and the fact that money is still getting tighter and tighter and guidelines more and more restricted will only compound this issue in the near future. CMHC is slated to release some new guidelines any time soon, and I suspect that their “Self Employed Simplified” program will disappear or reappear in a far more conservative form. This could make it far more difficult for self employed borrowers who show no income to get qualified. Given the very high percentage of self employed borrowers in BC, this will have a disastrous effect on real estate prices if we are correct. I hope that we aren’t.

So, if prices continue to decline, should you still buy?

The answer depends on your plans:

1. If you intend to buy and hold it for 5 years or more, then yes you should still consider purchasing rather than renting.

2. If you are buying an investment property, I would likely shy away from the Vancouver market in the next year.

3. If you are intending to flip the property, DO NOT get into this market. I have many, many buy-and-flip investors who have purchased properties, poured $100K into them, and cannot sell them for their original purchase price at this point. Buy and flip is not shrewd in this market unless you are buying at a substantial discount and putting essentially no capital into it.

The bottom line is that if you are buying a home, long term, you should always get into the market, buy as much house as you can afford, and let history, scarcity, and payments do the rest for you. You will always come out ahead, and I defy anyone to prove a 10 year period in Canadian history where if you purchased you would have been better off to have rented. That period doesn’t exist, and for that reason, buying property in Vancouver is still a good LONG TERM investment.

Happy hunting!

I found this article in the CIBC World Markets Forecast for September 23, 2008 written by Jeff Rubin entitled, “The Big Easy.” I found it to be a very accurate look at things, in my opinion, and have republished it here:

All of a sudden there appears to be an exit door from the credit crunch. The billions of illiquid, underwater mortgagebacked securities that have already bankrupted some of the world’s largest investment banks and choked up the world financial system are about to go away. The US Treasury, in an act of unprecedented charity, will effectively nationalize Wall Street’s most troubled assets and transfer them to the balance sheet of American taxpayers. What the ultimate cost would be of not intervening will of course never be known.

Both the slowing rate of recent housing price declines and vastly improved housing affordability ratios suggest that a trough in US real estate prices is probable within the next six months. But could Washington have waited that long before world financial markets would have totally seized up causing a global meltdown?

While the cost of taking another path will never be known, the cost of the one chosen is clear enough. Higher deficits can only bring higher taxes and higher inflation can only bring higher interest rates. Both are on their way in the American economy. The big easy in today’s  Fed/Treasury policy sets the stage for mean reversion in tomorrow’s policies. The world’s largest financial bailout is sending oil short-sellers to the sidelines. The earlier plunge in energy prices now only sets the stage for even higher inflation rates next year as oil prices rebound to set new highs.

With fears of a financial system meltdown and growth collapse averted, prices for a range of commodities have already seen their lows. The weak OECD backdrop will slow the extent and pace of recovery. Still, the combination of strong emerging market demand and limited new supply should see oil prices average a record-high $150/barrel over the second half of next year.

The resulting near-$5/gallon gasoline prices will see CPI energy inflation make a triumphant return, posting no less than a 40% increase from yesterday’s deleveraged prices (Chart 1). That, in turn, should see headline US CPI inflation punch through 6% towards the latter half of next year.

The last time CPI inflation was 6% was 1990 when the federal funds rate was 7½%, or almost four times today’s setting. US real interest rates haven’t been so negative since the second OPEC oil shock, nearly thirty years ago (Chart 2). Never have they remained so. And neither will they this time.

While the present job shedding in the US economy, and possibly a negative fourth quarter will keep the Fed tolerant of today’s inflation, any stabilization in employment will bring the onset of Fed tightening. The Fed should begin raising the funds rate by early in the second quarter of next year. Once started however, they have a long way to go. By year-end they will have hiked the funds rate by 200 basis points, in what is likely to be a protracted and painful adjustment in real interest rates.

Main Street was never as much at risk as Wall Street, but the US economy has bled jobs for the last eight months and will probably continue to do so for the balance of the year. And certainly growth and employment prospects are no better in Europe or Japan. But the OECD economies don’t pack nearly the same weight in global economic growth as they once did, and global growth is unlikely to fall much below 4%.

For the commodity- and particularly energy-leveraged Canadian economy, the Treasury bailout is unambiguously good news. After all, it won’t be Canadian taxpayers that are on the hook, while it will be Canadian resource and energy companies that will benefit from the stability brought to financial markets and the more bullish outlook that shines on world growth.

While growth in the OECD economies is likely to grind to a halt by year-end (Chart 3), global growth should regain a four-handle by next year. That will fall short of the near-record pace of growth of the last several years, but it will be more than sufficient to boost the energy and commodity-laden TSX.

The TSX is likely to take a run up to 14,000 before feeling the bite of interest rate hikes later next year. Not having cut rates as much as the Federal Reserve Board, the Bank of Canada will find itself in the enviable position of not having to raise them as much on the way up. The Bank is likely to do no more than half the Fed’s 200-point rise while the loonie breaks through parity again on the back of climbing crude prices.

While Canadian growth should also stumble during the second half of this year, rising energy prices next year will once again add momentum to both corporate profit growth and income gains throughout the resource-dominated Canadian economy. GDP growth rates back in the 3% area by the second half of the year should halt the rise in the national jobless rate which is likely to peak at just over 6½%. But inflation, stoked by the same energy price pressures felt south of the border, will re-ignite, suggesting the Bank of Canada’s work, like that of the Federal Reserve Board, may not yet be done.

I frequently have people come to me for a mortgage, and after I get them approved, get them a rate, and get it all lined up, they drop this line on me, “we are first time home buyers. Do we get a better rate or something like that?”

The answer: no.

There ARE benefits to being a first time homebuyer, but mortgage rate is not one of them. First time homebuyers pay the same rate (sometimes higher if they don’t have an established banking relationship with their bank) than people with established credit repayment histories.

The second question is: “do we have to pay the full CMHC fees as first time buyers?”

The answer: yes.

The only way to get a reduced CMHC premium is by purchasing an energy efficient home with an R rating of 77 or higher, or by already paying CMHC premiums in the past and needing to buy again.  Being a first time homebuyer doesn’t help you with the banks.

So where does it help you?

In most cases, it doesn’t. However, there are two elements of being a first-time buyer that are helpful:

1. You can withdraw up to $20,000, tax free, from your RRSP to assist in purchasing a home. This money can be used for a down payment, furniture, moving costs, or none of the above. It is up to you. This is only available to first time homebuyers (or those that have not owned property for 7 years or more). There are some repayment terms that you will need to be aware of. You will have to repay the $20,000 (or whatever you took out) over the next 15 years in 1/15th instalments. Failure to make an instalment simply means that the 1/15th for that year gets added to income and taxed. Alternatively, if you just continue making RRSP contributions, you can allocate whatever portion you like as a Home Buyer plan Repayment.

2. Property Transfer Tax. As a first time homebuyer, you can avoid the Property Transfer Tax (PTT) one time in your life. This can be a substantial savings, and should not be overlooked. If you are purchasing a property up to $425,000 (up to $450,000 with a pro-rated tax payment) you can avoid the tax altogether. The tax is calculated as 1% of the frist $200,000 of purchase price and 2% of the balance. So, on a $400,000 purchase, the tax would be (200,000 x 0.01) + (200,000 x 0.02) = $6,000!!! This is a huge savings a first time homebuyer, and is what people are referring to as first time home buyer discounts or advantages.

People often lose their ability to avoid this tax when their parents put the family home in their name as a child. The parents often are just trying to avoid the tax themselves, and fail to realize that this will have a huge impact on their children in the future. If you have owned a principle residence (technically anywhere in the world although it is tough for the government to police) then you are disqualified from this first-time home buyer savings.

Other than that, being a first time home buyer is the same as being a fifth-time home buyer or tenth-time home buyer. The process is costly, and there is little that can be done to get around this reality.

By this point, with the media blitz that has been underway, people have become aware that mortgage rates are on the rise. As I type this at 11:55pm at night, my last lender with low rates has moved them up. However, there are a number of permutations, variations, and specialty products that exist with the great older rates.

The first variation that exists is the Quick Close product. If you can close a mortgage in 30-45 days then special rates may apply to you as the lenders do not have to “hedge” for rates rising. That is 30 to 45 days from the date that your broker submits the deal, NOT since the offer was accepted (in the case of a purchase), nor is it from the date you and the broker talked about it. It is from the date he or she submits the deal to the lender. I have access to several lenders offering lower rates if you can close a mortgage quickly.

The next variation on a theme is the Jumbo Mortgage. These products are mortgages that exceed some lender-determined size and that qualify for a deeper discount as a result of their size. The most common point is $500,000 of mortgage amount. Any mortgage over $500,000 qualifies for a special deep discount. As of typing this email, 4.99% is still available for people with mortgages exceeding $500,000.

The last variation I’ll address is the Promotional Rate Offer. These are one-off products that have to fit certain size / closing date / applicant type. These are very specialized and you need to speak to a broker to see if there are products specially designed for an applicant in your unique position.

As I type this, I am able to give applicants the following promotional rates if they fit a specialized “box” regarding their employment, credit, financial situation, assets, income, and property:

5 Year Closed – 4.99%

5 Year Variable Closed Prime – 0.80% (Prime is presently 4.75% for a net rate of 3.95%

These rates are subject to change without notice, subject to the applicant meeting specific criteria, and are subject to closing in a specific time frame, but in either case, ask me if you qualify.