A month ago, I tested a theory that only people who have mortgages truly understand what they are. The same, I believe, is true for interest rates. We know it\u2019s the price we pay for getting a loan and that we want the lowest rate possible \u2014 but do the majority of us actually understand what\u2019s behind the percentage?<\/p>\n
Interest rates are the grown-up equivalent of kids asking where babies come from. They show up one day (when we buy a place) but there are some major plot holes. Who decides what the interest rates are that day? How are they calculated? Should I get a variable or fixed mortgage rate? When do I start paying off the actual loan, instead of the interest? The more I learned about interest rates, the more I felt like David at the dentist.<\/p>\n
With the help of Toronto-based mortgage agent Lisa Okun, we\u2019re breaking down WTF interest rates actually are, how they affect your pocketbook over the life of your mortgage, and where they come from (spoiler alert: the answer isn\u2019t storks).<\/p>\n
Let\u2019s start at the very beginning. WTF is a loan?<\/strong><\/p>\n Borrowing money is great but there\u2019s always a catch: interest. For mortgage loans, the interest rate is applied to the principal \u2014 the amount your lender gives you after you contribute the downpayment. For example, if you bought a condo for $500,000 and put down 20 percent ($100,000), the interest would be applied to $400,000 (the principal). Then you sign a contract agreeing to pay it back by a predetermined date. This is your amortization period (which can range from 6 months to 35 years) in periodic installments (most people make mortgage payments every month).<\/p>\n Your first mortgage payments will be interest-heavy. As your loan\u2019s principal goes down over the years with more payments, so too does the interest you\u2019ll pay on it.<\/p>\n Interest rates will not stay the same over the entire life of your loan. When a lender gives us a loan, we are contractually bound to them for the \u201cterm\u201d \u2014 the length of time you commit to the interest rate, lender and associated conditions. Term lengths can range from 6 months to 10 years, and gets renewed \u2014 either with your current lender, or you shop around for another one \u2014 after the term period is over. With shorter term lengths, you get access to lower rates.<\/p>\n \u201cThere are more competitive rates if you take a shorter term, usually. But you\u2019re putting yourself in a riskier position because if you take a two year term, at the end of it, you don\u2019t know what the rates are going to be,\u201d says Okun. \u201cThe reason the banks push these better rates with shorter terms is because they expect the rates to go up in two years and they\u2019ll be able to roll you into a higher rate. If you had just taken the five year rate at the outset, you would have probably been in a more advantageous position at the end of it.\u201d<\/p>\n Who decides what the interest rates will be?<\/strong><\/p>\n Mortgage rates will rise and fall over the life of your mortgage. Larger economic factors generally determine if they\u2019re low or high. Interest rates decrease when dark clouds settle over the economy. Whether it\u2019s insecurity in a foreign market, rising unemployment or an asset bubble popping, you can expect these economic forces will cause an interest rate rollback. In Canada, lending rates bottomed to historic low levels during the financial crisis in 2008 caused by the US housing bubble popping. Mortgage rates increase when the stock market is strong, foreign markets are stable, and jobs are plentiful.<\/p>\n \u201cFor the last few months \u2014 which is the first time in quite a few years that this has happened \u2014 rates actually started to go down. It\u2019s been an environment of rising interest rates for at least a year,\u201d says Okun. \u201cThat\u2019s based in part on the Bank of Canada\u2019s assessment of how the Canadian economy is doing, which is related to all sorts of things: our oil industry, our relationship to the United States, our housing market and so on.\u201d<\/p>\n The Bank of Canada uses this information to set the prime rate (otherwise known as the prime lending rate), which Canada\u2019s major banks use to set interest rates for variable mortgages and other loans. The prime rate is primarily influenced by the Bank of Canada\u2019s overnight rate \u2014 the interest rate at which banks borrow funds from one another overnight. What you need to know is this: \u201cThe Bank of Canada reviews the overnight rate eight times a year. When the overnight lending rate goes up, the prime rate is probably going to go up too. If you have a variable rate mortgage, that\u2019s the announcement you\u2019re going to be looking for,\u201d says Okun.<\/p>\n \u201cRight now, the Bank of Canada doesn\u2019t feel our economy is growing in the way they want it to, so they\u2019ve decided to keep their overnight rate steady. Banks have the discretion to set their rates how they please, so we\u2019ve been seeing drops there. This has been really encouraging for people who are looking to buy right now,\u201d says Okun.<\/p>\n WTF is the mortgage stress test?<\/strong><\/p>\n In January 2018, new mortgage rules were introduced that require all Canadian homebuyers to take a stress test in order to qualify for a mortgage from a federally regulated lender \u2014 this usually means one of Canada\u2019s five major banks.<\/p>\n If you\u2019re contributing at least 20 percent to your downpayment (meaning you\u2019re an uninsured homebuyer) \u2014 you will have to meet either the Bank of Canada\u2019s five-year benchmark rate (currently sitting at 5.34 percent) or the rate offered by your lender plus 2 percentage points. Whichever percentage is greater will be the rate you have to test your finances against.<\/p>\n Planning to put down less than 20 percent? You will default to an insured mortgage and will also be measured against either the benchmark rate or the rate offered by your lender (without adding 2 extra points).<\/p>\n For anyone with an uninsured mortgage (you put down at least 20 percent), Okun shares this example: \u201cRight now, rates are kind of low. We\u2019re seeing rates around 3 percent or a little higher. So they will have to stress test against the benchmark 5.34. But if you have a rate that\u2019s 4.99, you will need to qualify at 6.99,\u201d says Okun.<\/p>\n If you\u2019re putting down less than 20 percent (and defaulting to an insured mortgage), you will also be measured against either the Bank of Canada\u2019s rate or the rate offered by your lender \u2014 without adding two extra points. In the previous example, if your interest rate was 3 percent, you would still have to qualify at 5.34 percent.<\/p>\n Not everyone has access to the same interest rates.<\/strong><\/p>\n The Bank of Canada is driving the car when it comes to interest rates, but you\u2019re along for the ride, too. Things like your credit score, debts, downpayment amount and the type of mortgage you get will impact what interest rates are available to you.<\/p>\n \u201cThere are different interest rates if you\u2019re getting an investment property versus an owner-occupied property, if you\u2019re planning to buy a second home versus your primary residence, if you\u2019re getting an insured mortgage versus an uninsured mortgage \u2014 there are all sorts of different programs out there,\u201d says Okun.<\/p>\n If you put down less than 20 percent, you default to an insured mortgage and get access to lower rates. This is because you\u2019re paying a hefty insurance premium to CMHC, meaning that if you were to default on your mortgage, your lender would be off the hook. Less risk for your lender, lower rates.<\/p>\n It doesn\u2019t seem fair to be penalized with a higher interest rate when you\u2019ve worked so hard to save for a downpayment over 20 percent. But even though the rates appear more attractive for an insured mortgage, people always end up paying more monthly. This is because they\u2019re getting dinged with the insurance premium. In addition, their downpayment is smaller, so they\u2019re usually paying interest on a larger loan.<\/p>\n Your credit score is also key. \u201cIf it\u2019s above 680, you have access to the best rates,\u201d says Okun. But with lower credit scores, lenders actually add a predetermined amount of basis points to your interest rate depending on the range you fall in \u2014 making the rate climb.<\/p>\n Rates also vary from lender to lender \u2014 which is why it\u2019s important to shop around. \u201cEvery lender structures it differently, so finding the one that works best for you is really a matter of working with someone who understands what you\u2019re looking to do and can do the shopping for you,\u201d says Okun.<\/p>\n How long will it take you to pay it off?<\/strong><\/p>\n The sooner you pay off your loan, the less interest you\u2019ll pay in the long run.<\/p>\n \u201cThe longer your amortization period, the lower your monthly mortgage payments are going to be because you\u2019re stretching your mortgage out over, say, 30 years instead of 25. You\u2019re going to get the lowest possible monthly payment at 30 years but you\u2019re also going to be ultimately paying more interest because you\u2019re doing it over a longer period of time.\u201d<\/p>\n Okun recommends taking the longest amortization available to you because you can always expedite it with lump sum payments or prepayment privileges. This way, if you ever find yourself in an unsavoury financial situation, you can stretch your payments to the maximum amortization and get some relief.<\/p>\n Are you getting a fixed or variable mortgage?<\/strong><\/p>\n If you get a fixed mortgage, the rate you settle on will be your rate for the entire term of your mortgage. A variable rate is going to fluctuate based on what direction the prime rate is moving in.<\/p>\n \u201cWhen you get a variable rate, you get a discount on the prime rate. Depending on the discount, it could be prime minus 95, prime minus 35, prime minus 1.05. As prime fluctuates, so will your rate. If prime happened to go down, you would still get that discount.\u201d<\/p>\n At the time of writing, prime is at 3.95 percent for most lenders. So if your variable rate was prime minus 95, your interest rate would be 3 percent. If prime increased to 4 percent, your discount would hold steady and you would pay 3.05 percent.<\/p>\n Historically, variable rates tend to do better. \u201cWith a variable rate, there is often an opportunity to save money, but you have to be comfortable with some risk,\u201d says Okun.<\/p>\n Do interest rates affect home prices?<\/strong><\/p>\n The answer is yes and no. \u201cIf you look back historically at what interest rates were 30 years ago, they were a lot higher and home prices were a lot lower. Usually when rates go up, home prices go down a bit,\u201d says Okun. \u201cObviously, it depends where you\u2019re looking. We\u2019re in Toronto where prices are pretty inflated as it is and then there are some neighbourhoods where home prices just go up regardless of what\u2019s happening with interest rates. It depends on supply and demand.\u201d<\/p>\n When mortgage rates are higher, people are less likely to list their homes and sign on for a new mortgage. \u201cPeople have to move somewhere,\u201d says Okun.<\/p>\n