Home > Uncategorized > Fixed-Rate Mortgages Aren’t Betting Against The Bank

Fixed-Rate Mortgages Aren’t Betting Against The Bank

The debate about fixed rate vs variable rate mortgages has to be as old as Canada’s oldest bank. For just about as long, people have been comparing fixed rates to insurance. You get some certainty but the bank makes a profit from you on average. And they know enough to come out ahead. Is that still true?

If you’re talking about an institution that finances its mortgages from deposits then it’s true that they would want to set a fixed rate that avoids creating a loss for them and gives them a bit of protection for future changes. But those institutions are rare these days. And if the interest rate they pay on deposits doubles from 0.001% to 0.002% it’s not a big loss. It seems much more common for fixed rate mortgages to be financed by selling bonds now.

That means all those 5-year mortgage rates are really in competition to get money in place of other 5-year bonds. Which means the interest rate would be driven by the bond market, which is affected by things such as how believable the government’s fiscal policies are and how scared people are of stocks this week. Even institutions that don’t issue bonds could use an interest rate swap to take advantage of low yields in the bond market.

Not that the bond market is dumber than banks. “Bond market vigilantes” have brought light to empty promises many times by demanding rates that reveal the bond issuer’s lie. But for all the smart money in the bond market, it’s still open to be driven down to ridiculously low (or high) rates when uninformed people panic over incomplete information. This won’t happen all the time, but is it more likely than a bank setting a 5-year rate that costs them money?

To summarize, if fixed rates are influenced by bond markets and bond markets are driven by millions of emotional investors then you’re not betting against the bank by taking a fixed rate. You’re really betting against what other investors feel. And if you think the emotions are going in the wrong direction it just might be a wise bet to take advantage of low interest rates while they’re available if you have a need to borrow.

On that note, after 1 year in a 5-year fixed rate mortgage we have switched to a new 5-year fixed rate of 2.99%. This is from a local credit union and I don’t think they issue mortgage bonds. Does this mean we’re betting against them? I don’t know the answer, but we don’t have much to lose by holding on to today’s rates for a few more years.

  1. Joe
    March 29, 2012 at 12:44 am

    Banks and credit unions are only issuing mortgages with rates at which they can make a profit. Credit unions are owned by members and are therefore awesome; they can reduce the “spread” on loans/deposits, which saves everybody money.

    I think the real story in mortgages, however, is the manner in which the CMHC artificially distorts the mortgage market. In turn, this has fueled our housing bubble.

    • March 30, 2012 at 3:25 pm

      A lot of people still talk like the lender makes a profit by simply keeping the mortgage for the full term and using deposits to fund it. With many lenders issuing mortgage bonds this seems to be less common, and the bank can lock in its profit on day 1 by issuing corresponding bonds and collecting the difference over the life of the mortgage. So when considering a fixed rate you could ask how smart the bond market is, not how smart the bank is.

      As I learned a few days ago smaller credit unions do in fact (sometimes) sell mortgages to larger institutions so they can play the same game. While making the decision I didn’t consider the membership benefits of the credit union which may double our savings from switching.

      I wouldn’t mind seeing some changes to the CMHC. The only thing that mars the low rates we’ve been able to secure is the fact that much less qualified borrowers can get them too! I would rather borrow at 10% when the average is 12% than borrow at a 3% rate that everyone can get. Seeing a bigger advantage for true low-risk loans would be great.

      • Joe
        March 31, 2012 at 2:20 am

        Yes, qualified borrowers have been subsidizing sub-prime borrowers in the Canadian mortgage. Big time. Ending the distortion of the free market is the only solution.

        As for the small credit unions you reference — yes, they are much more sophisticated than most people would assume. I worked for one as a summer job. In Ontario, CUCO enables a ton of very small credit unions to operate on a cost effective scale in the world of corporate finance, while still delivering the lcoal service you’d expect from a credit union. I’ve also worked for one of the Big Six. I have my primary chequing account with a credit union. What does that tell you? lol.

  1. December 6, 2012 at 4:53 pm

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