Interest rates are plunging — so why aren't mortgage rates?

Central banks around the world have slashed their benchmark interest rates to pretty much zero in an attempt to stimulate the economy by making it as easy as possible to borrow, spend and invest.

But a curious thing is happening in Canada's mortgage market: rates aren't going down by as much as they probably should be. And in some cases, they're actually rising.

"Usually when the Bank of Canada cuts rates like they have, by 1.5 percentage points in a month, you can expect all rates to fall," said James Laird, president of mortgage brokerage CanWise Financial and co-founder of Ratehub.ca.

"At first they did ... but a week and a half ago, we started to see a shift [and] now we are seeing our lenders increase rates. Every two days, we get a different lender saying we are going up by point one, point two."

Mortgage rates tend to move up and down based on a number of factors, but one of the main ones is the costs borne by the lenders themselves.

People tend to think that when someone walks into a bank to ask for a home loan, if they are approved, the bank just takes the cash out of some safe at the back, hands it over to the borrower and charges them interest over time to make a profit.

But, in fact, banks don't keep that much money just lying around either — they typically borrow it themselves and make money on the spread between how much they're charged for it and how much they turn around and charge the borrower for it.

Fear driving rate cuts

The cost of financing a variable rate loan is strongly influenced by the Bank of Canada's benchmark rate, because banks tend to set their own prime lending rates based on whatever the central bank's rate is.

The bank has cut that rate by 150 basis points — 1.5 percentage points — in the past month to try to make it as easy and cheap as possible for people to borrow, spend and invest to stimulate the economy that has been waylaid by COVID-19.

A few short weeks ago, it wasn't hard to find a variable rate mortgage for something around prime minus one — a full percentage point below whatever a bank's prime lending rate was at the time.

But a funny thing has happened since then. Prime lending rates have gone down more or less in lockstep with the Bank of Canada's moves, but those discount rates for mortgages have evaporated.

"About half of the savings have been passed along and half kept by banks for a higher margin," Laird said.

The reason they're doing that is the same as why stock markets plunged and governments rushed to implement lockdowns on millions of people: fear.

"Lenders are saying, 'Hold on a second,'" Laird said. "If a million people are going to lose their jobs and unemployment is going to rise, maybe we should build in a bit of a risk premium to our pricing to account for possible defaults for this new money we are lending."

Banks building in higher risk

When the economic outlook was more clear, banks were happy to cut rates as low as possible to try to gobble up market share. But now, they're saying "We better earn a bit more of a spread on this money because these things might default at a higher rate than we're used to," Laird said.

The impact isn't dramatic. Laird says a few weeks ago, the best mortgage rates were something in the range of between two and 2.5 per cent. Today, they're between 2.5 and three per cent because, as he puts it, "they are demanding a higher risk premium than what they typically do."

Others aren't quite so diplomatic.

"It's total garbage," Marcus Tzaferis with mortage brokerage Cannect said. "It's complete profit taking."

While banks borrow at a rate slightly above that government rate, Tzaferis says "the spread between their cost of borrowing and some of their five-year fixed mortgage rates is still around 250 points, which is highly profitable for them."

Fixed-rate loans aren't pegged to the Bank of Canada's rate and are instead more influenced by the bond market. And there, too, Tzaferis says what's happening in the market doesn't reflect what's happening behind the scenes.

Lenders finance fixed-rate loans on the bond market, where yields have fallen to record lows in the current COVID-19 crisis. The yield on a five-year government of Canada bond bottomed out at around 0.37 per cent this month and is currently hovering just over 0.5 per cent. 

Push for 5-year mortgages

Though banks must pay a credit spread on bond yield and that may be widening, Tzaferis says they are also widening their profit margins. Most fixed-rate mortgages are currently going for around three per cent, he points out.

The difference for borrowers adds up fast. Laird calculates that a theoretical buyer who put down a 10 per cent deposit on a house costing $500,000 before this crisis would likely have been able to get a mortgage rate of 2.6 per cent, which would make their payment $2,102 a month.

If all three rate cuts since then were to be fully factored into that loan, that borrower's monthly payment would fall as low as $1,769 a month — that's $333 per month or $3,996 per year on their mortgage payments, compared to what they were paying less than a month ago.

The overwhelming majority of first-time buyers opt for fixed-rate loans because they like the security of knowing that their monthly payment is guaranteed to not increase. The banks know this, Tzaferis says, and it could soon have a heavy cost for borrowers.

"They're using this as an opportunity to lock people into big fat juicy and profitable five-year mortgages," he said. "When their rates drop those consumers are going to have massive penalties to break them ... tens of thousands of dollars."

"It's absolutely insanity," Tzaferis said. "This is a totally manufactured crisis to profit."

COVID-19 recession on horizon

Laird and Tzferis both say that the current situation can't last forever. Economists are already predicting that the COVID-19 recession is likely to be incredibly sharp, but it's anyone's guess how long it will go on for.

Laird says the best sign that things are getting back to normal will be when the big banks start to act in a way that seems paradoxical.

Banks are raising their rates right now because they feel just as uncertain about the future as Canadians do. Once that cloud lifts, they'll want to start lowering rates again, and "they won't build in that uncertainty premium like they are now," said Laird.

"As confidence returns, you'll see rates fall."