- Hey, welcome back.
It's Nolan Matthias from Mortgage 360
and today we were discussing everything mortgage math.
Well, not everything mortgage math
specifically how mortgages are priced
and how the bank determines how much
they're going to charge you.
And what you'll find at the end of this video
is that all comes down to profits
but for the mortgage nerds out there
we're gonna get into the details
of how they determine what those profits are going to be.
But before we get into it
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Okay, so let's get into it.
How are mortgages priced?
And the first thing you need to understand
about how mortgages are priced is it's all about two things.
One is risk and two is profits.
And when the bank looks at any particular mortgage
or mortgage rate what they're trying to do
is balance risk with profits.
So at the end of the year
they can report to their shareholders, how amazing they are
and how much profits they made off of mortgages.
So the basics of how mortgage interest rates are calculated
is basically that the bank is charging you a premium
over what it costs them to borrow the funds
or over what their opportunity cost is
if they were to invest in something else.
So in other words
how banks typically work is they take funds
from you when you deposit your money
into the bank account every single month
when you get your paycheck.
And they basically say, okay, we now have these funds.
We're going to lend it out to other people
at a higher interest rate than what we're charging you.
And most bank accounts will have savings accounts
will have basically an interest rate that you get
for having money in there.
And what the bank is doing is they're taking advantage
of those funds and using it to lend to other people
at a premium.
And that premium prices in the risk of you
not paying back the mortgage.
Their funding costs are generally driven by interest rates.
And interest rates include things like,
the Bank of Canada's key lending rate
and Bank of Canada government bond rates,
as well as other secure bonds that would be sold
in the open market.
And basically what happens is when you have
strong economic growth interest rates go up because
the central banks are trying to slow the economy down.
And when you have poor economic growth,
interest rates go down because the Bank of Canada
or the federal reserve bank or whichever central bank it is
in whichever country you are in,
is trying to spur the economy on.
So they're lowering interest rates.
And this is why when things like a pandemic happen
you see mortgage rates respond accordingly and go down.
When you see things like the financial crisis in 2008
happened you see interest rates respond accordingly
and they go down.
And that corresponds obviously
to your mortgage rates as well.
Now sometimes weird things happen.
Like when the pandemic happened in early March
and interest rates dropped to all time lows
there was a refinance boom.
And there's also a lot of uncertainty around liquidity
in the market.
So as a result what you saw was this brief period
where when interest rates should have been going down
they actually went up because banks were essentially afraid
that they were going to run out of money.
So they started increasing the prices of mortgages
in order to slow down borrowing.
Now as the Bank of Canada intervened
and started buying mortgage backed securities
interest rates started to go back to normal.
And that's why you see interest rates where they are now
which is closer to the 2% range
instead of the two and a half percent range.
So the bonds that are most typically tied to mortgage rates
in Canada are the government bonds
that are closest in length to the mortgage
that you were getting.
So, in other words, if you're getting a five-year mortgage
they're typically tied to the
five-year government of Canada bond.
If you're getting a three-year mortgage
they're typically tied to the three-year
government of Canada bond and so on and so forth.
And on average,
the spread between the Canada government bond
and the mortgage rate that you're getting is typically
between 120 basis points and 180 basis points
or 1.2 and 1.8%.
And that's depending on who you ask
because if you ask a lot of bankers
they'll say it's closer to 180 basis points.
That's because they typically charge higher rates
and have over the longterm.
If you ask brokers like myself
for the last 17 years that I've been in the business
generally the spread has been about 1.2%.
So if a bank of Canada bond is selling 4.7%
then typically the five-year fixed mortgage rate.
If it's a five-year fixed Canada bond
that we're comparing it to is typically about 1.9%.
Now there's other things that go
into mortgage pricing as well.
And this isn't so much with a mortgage broker
but very typical with a bank.
Things like your credit can affect your pricing.
So if you have low credit or bad credit
you'll typically pay a little bit more
than if you have good credit.
Now, most people in Canada
actually have pretty exceptional credit
and kind of the breakeven score
of where you'll start paying more for an interest rate
is when you start to get a credit score below about 620.
Most Canadians and a lot of the people that we see about 95%
of our clientele, comes in at above 620 beacon score.
Now another factor that affects interest rates
is prepayment risk.
Yes, your mortgage typically comes
with prepayment privileges, and that is a risk
to the lender because the faster you pay off the mortgage
the less they will make in profits.
So lenders factor to this, and that's often
why you'll see banks offer no frills mortgages
with low prepayments
is because they want to eliminate their prepayment risk
and therefore be able to offer you a lower rate.
That's also why an open mortgage is priced so much higher
than a closed mortgage
it's because there is no penalty for you get out of it
which makes it more likely that you'll pay it off sooner.
And that just goes to show that mortgages
are like anything else, you get what you pay for.
And if you're paying a ridiculously low rate
there's a very, very, very good chance
that you're getting less features
because the bank is trying to minimize their risk.
So that's why it's important to understand the difference
between getting a great rate
and getting great value in your rate
because having the ability to prepay your mortgage faster
or having a lower penalty are all things
that allow you more flexibility in the long run.
And having more flexibility in the long run
is what allows you to take advantage of
when pricing changes.
So when rates go down
when the government bond yields go down
and you have the flexibility to move to a different lender
or pay out your mortgage, because you have a low penalty
that's ultimately where you get the savings
in your mortgage.
It's by taking advantage of the differences in value,
instead of trying to take advantage
of getting a low rate and then being locked into it
for an extremely long period of time.
So as far as fixed versus variable rates go
fixed rates are very much determined based on
the comparable Canada government bond yield.
So variable rate on the other hand
is priced a little bit differently.
It's still based on their cost of funds
but their cost of funds is typically different.
Their cost of funds is typically determined
by deposits that they have on hand or by short-term GICs.
And that's why when you see variable rates advertise
you typically see them advertised
as prime plus or prime minus.
There's always a factor involved
compared to what prime rate is.
And that's because the cost of funds can vary.
It can go up and down in the same way that fixed rate costs
of funds can go up and down.
But the prime rate isn't necessarily
what's driving the price.
Yes, it's a factor, but it is more a benchmark
for the banks to help them determine what's happening
in the economy and how they should be pricing
their variable rate mortgages.
It's not necessarily that the bank is borrowing the money
directly from the Bank of Canada and the Bank of Canada
is setting their cost of funds.
So how is this information helpful to you?
Well, let's say you have a variable rate
and you want to try to determine
where interest rates are going.
Well, if you watch the five-year government of Canada
bond yield on a regular basis
and you see it start to spike, that's usually an indication
that interest rates are going to go up.
And that sort of information can help you determine
what to do with your variable rate mortgage.
Now, that being said, interest rates fluctuate a lot
especially government of Canada bond yields.
They fluctuate quite frequently
and on a moment to moment basis.
So what you don't wanna do is
you don't wanna be watching them religiously.
And then at the earliest sign of a spike go in lock in.
Because what happens is interest rates will fluctuate
when they go up they will come back down
and sometimes a blip in the radar is nothing more
than a blip in the radar.
So you need to be careful that you don't go
and act too quickly when you see interest rates
start to go up but you can definitely use it
as an indicator
if you want to hang out on the internet
and basically watch what's happening with interest rates.
The other way you can use this information
is if you're negotiating for a mortgage rate
and you know that typically interest rates
are around 120 to 180 basis points
above the five-year bond rate, for example
on a five-year fixed, what you can do
is you can look up the five-year
government of Canada bond yield
and then use that information to determine
if the price you're paying is actually a good value.
Now, again, this video is mostly
for the mortgage nerds out there.
So if you found this video useful, awesome
hit that subscribe button hit the notification bell,
hit the like button so more people like you
can see this video, and if you are in a mortgage nerd,
you probably are still here.
So thank you for watching anyways.
And we'll see you on the next video
where we talk about something a little bit more exciting.
Cheers.