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Home » Credit and Debt
An inside look at interest rates
Category :- Credit and Debt

Author :- Peter Cook and Robert Flee 
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Posted on October 18, 2014, 7:05 am
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Since we’ve been writing this column we’ve had many questions from our readers about the driving factors that affect interest rates. You may be wondering what makes interest rates move up and down, how are they set and how you may be able to predict their direction.

We have collected some of the most common questions and answered them for you in this issue.


How are long-term interest rates determined?

Long-term rates are based on a spread over bonds or the lenders’ internal cost of funds. Spreads will vary based on loan size for Canada Mortgage and Housing Corporation (CMHC) insured mortgages. Conventional mortgage spreads will vary depending on loan size, quality of the property, asset class, location and loan to value ratio.


Which bonds are currently used by lenders to establish your interest rate?

Lenders in this industry use various indexes to determine interest rates. Government of Canada bonds (GOCs) are generally used by life insurance companies and some banks. The Canada Mortgage Bonds (CMB) are issued by the Canada Housing Trust created by CMHC and are backed by the Government of Canada. Securitized lenders are currently using the CMB market to fund their mortgages. During the recent credit crisis, the CMB has become the most popular and competitive source of funds for mortgages.

Cost of funds (COFs) are an unpublished “internal rate” offered by some of the major banks. COFs tend to vary between institutions and are not necessarily linked to changes in bond yields. The cost of funds generally refers to the cost at which the lender can access capital. They tend to fluctuate without clarity or consistency from one lender to another.


What causes bond rates to fluctuate?

There are many factors that cause bond rates to change. They will move based on speculative and actual changes in the economy. Some of the factors include changes in the unemployment rate, retail sales statistics, Gross Domestic Product announcements and housing starts. Political uncertainty, natural disasters and major world news such as acts of terrorism may also have an effect.

Inflation or the mere expectation of inflation is one of the biggest factors that will increase bond rates -- if it rises, bond rates will rise and vice versa. Inflation is directly related to the strength of economic growth.

Low inflation driven by the recent weakness in our economy has helped maintain the current low interest rate market.

Investment alternatives also influence bond rates. A migration to other investments can result when there is significant economic change. For example, a sudden increase in the stock market tends to move investors out of bond markets and into equities usually moving bond rates higher.

Currency also plays a big part -- when the Canadian dollar is strong and stable, more foreign investors buy Canadian bonds helping to support a lower bond rate. If the domestic currency is fluctuating or weak, bond rates may increase as foreign investors move to less volatile currencies.


Why is it difficult to determine where long-term rates are headed?

Simply put, it is impossible to predict the multitude of variables and factors that influence interest rates. It seems to be the “surprises” that move rates the most.

Who could have predicted:


The rapid decline of global stock markets?

Hurricane Katrina?

The subprime mortgage crisis?

The recent climb of the Canadian dollar?

High unemployment in the U.S.?

The European debt crisis?

The BP Oil disaster?


These, among others, are all factors that may have caused fluctuations in interest rates.


How does the U.S. market and global markets impact Canadian interest rates?

U.S. and global economic news will significantly influence Canadian bond rates. In an increasingly global economy, the strengths and challenges abroad can have a large impact in Canada. The shear size of the U.S. economy and the impact it has on the rest of the world will affect the Canadian economy and interest rates. This is why Canadian and many other bonds tend to follow the U.S. market despite the economic situation at home.


Why does the prime lending rate not impact long-term rates?

The prime rate is based on the Bank of Canada rate which is adjusted by the Governor of the Bank of Canada. Long-term lending rates are based on the bond market which, as mentioned earlier, moves on future speculative and actual economic data. The Bank of  Canada sets its overnight rate (BOC) then banks in turn set their prime rates for variable loans and mortgages.

The bond market in effect is anticipating the very events that will lead to changes in the BOC. The only way prime can really influence long-term rates is to the extent that the Bank of Canada surprises the bond market by moving the BOC rate unexpectedly.


Do lenders have inside information on the direction that rates are going?

There is no inside information as to whether interest rates will go up or down. There are only different views. As mentioned earlier, there are far too many variables to predict. Any lender that is offering you a prediction on the direction of interest rates can only be speculating.


Is there a time of day borrowers should set rates?

There isn’t a specific time of day that is best; however, most economic data is released between 7 a.m. and 9 a.m. EST, so those hours can be quite unpredictable.

This can be good or bad as bonds could suddenly move in either direction. Bond markets are most active before 2 p.m. and usually wind down by about 4:30 p.m. We generally recommend that our clients set their rate before 4:30 p.m. as the bond market becomes less active towards the end of the trading day. This becomes a moot point if you are dealing with a lender whose internal process delays your request by 24 hours or longer. It is to your advantage to deal with a lender that can set your rate immediately upon request.


How should borrowers determine whether to lock in for a five or 10-year term?

We suggest you remove the guesswork of trying to anticipate where rates are going because of the difficulty in predicting all the variables affecting interest rates. It should be a decision based on your business plan.



Staggering mortgages in your portfolio to mature at different times:

Financing a turn-around building -- use an open variable rate mortgage until renovations are completed then select a fixed term.

If you intend to unlock equity during the first five years, you may be wise to go with a five-year term to avoid a large pre-payment penalty you would incur with a 10-year term.

If you want the comfort of maintaining your Return on Investment and eliminate future uncertainty, consider locking in for a 10-year term.

The bottom line is that it is difficult to determine where rates will be nex t month , let a lone five years from now. Use common sense -- don’t try to over analyze the situation. Select a term that suits your business plan and portfolio.


What is your opinion on the direction of rates over the next five years?

Interest rates are already very low by historical standards so the speculation in many circles these days seems to be rates will eventually go up over the next few years. This is sure to happen if there is a firm economic recovery, which is not convincing at this time considering the economic problems around the world.

Following the credit and real estate collapse in Japan 20 years ago, various government stimulus programs and low rates did not create a sustainable recovery. The interest rates in Japan are still extremely low. Could the same result in North America? Who knows. Only time will tell. In the mean time, borrowers should be grateful for the extremely low interest rates currently available to refinance or acquire new properties while the timing is right.

We hope you have found the answers to these questions informative. There may be some unanswered questions on your mind that relate to renewing, unlocking equity or acquiring new apartment buildings. Please feel free to contact us for specific financial advice relating to your business plan.


Source: http://www.firstnational.ca/docs/comm/CAMFinancingAug2010.pdf

Comments : Peter Cook and Robert Fleet are Apartment Financing Specialists with First National Financial LP. Together they have originated over $4 Billion of mortgages. Their combined 32 years experience with mortgage financing has lead to frequent speaking engagements across the country.
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