Bond Markets & Mortgages – And why you should care

Do you own a house? If so chances are you have a mortgage. Simple.

I’m sure we all have a rough idea of what a mortgage is.. simply put it is a secured loan where your property/real estate is collateral in exchange for the money that a lender loans you to purchase said asset.

Mortgages like any other loan have a cost associated with borrowing the money – how else would a lender make money? We know this as interest, the amount of interest associated with each mortgage depends on the type of mortgage you buy – fixed rate, variable rate etc.. and each mortgage is valid for a fixed period of time before you need to either pay back the remainder in lump sum or re-finance your outstanding balance with a new mortgage on new terms. We won’t get into detail with any of these issues.. Google it if you need to.

What a lot of people don’t understand is HOW the interest on mortgages is set. We are all led to believe that interest rates are basically derived from the Bank of Canada’s key interest rate, this is the national benchmark rate that all banks, lenders and financial institutions use to determine what interest rates will be on their consumer loans and mortgages. During the Financial Armageddon in 2009 while the US Real Estate and Mortgage industry crashed, the Bank of Canada acted quickly to protect Canada’s Real Estate market from similar consequences by immediately cutting the key interest rate to near 0%, since then it has maintained this key rate at 1%. The reason behind this is simply to make the cost of borrowing money CHEAP and in turn entice people to continue borrowing and borrowing to buy more and more Real Estate and keep the economy “strong”

Mortgages have been dirt cheap for years now and the Bank of Canada has been very conservative in raising rates again out of fear that any rate rise would have drastic consequences on an already FRAGILE Real Estate market, putting buyers out of the market, killing sales and eventually leading to significant declines in house prices. This would be disastrous to millions of Canadians as they would quickly find themselves with mortgage loans that are worth more than what their actual houses are worth.. this is called being UNDERWATER.

*IMPORTANT* Here is what the majority of you don’t understand and what the mortgage brokers and salesman don’t tell you.. mortgage interest rates are not solely controlled by the Bank of Canada! The majority of all mortgage lenders actually borrow the money they use to create mortgage loans, and most of them borrow this money by issuing BONDS. Bonds are fixed notes of fixed value that consumers can buy that will expire in with a fixed term (5 or 10 years). All Bonds have a fixed interest rate or know as a coupon attached to it as well that is paid to the holder of the bond throughout the fixed term on top of the original value to the bond.

Example:

For example, say you buy a bond with a face value of $1,000, a coupon of 8%, and a maturity of 10 years. This means you’ll receive a total of $80 ($1,000*8%) of interest per year for the next 10 years. Actually, because most bonds pay interest semi-annually, you’ll receive two payments of $40 a year for 10 years. When the bond matures after a decade, you’ll get your $1,000 back.

So.. if mortgages are funded by bonds, then the interest rates on mortgages are directly connected with the interest rates on bonds.

Bonds are a market of their own, and interest rates on bonds are a completely separate matter, however over the past few weeks bond markets have EXPLODED, interest rates are spiking on all forms of bonds including the 10 year bond (mortgages are mostly comprised of these) and immediately effecting the interest rates on mortgages.. all of this without the Bank of Canada saying a word on its own key interest rate.

What does this mean? If the Bond Market continues to boom like it is now (and all indications point in this direction) then mortgage interest rates with be FORCED to follow suit, it is non negotiable. So what does this really mean to mortgage holders and those in the market for a mortgage today alike? Here is how Mr. Turner summarizes it:

Five-year money is at 3.39% (it was 2.89% ten weeks ago) and RBC has upped its 10-year rate to 3.99% (it was 3.69% one week ago). It sure looks like there’s more to come.

That means that 10 weeks ago a 5 year mortgage on a $300000 @ 2.89%  interest paid would be $40051

And today that same 5 year mortgage now at 3.39% would cost you $47143 – Difference of $7143 in extra interest not to mention the increased monthly payments.

All this and the Bank of Canada hasn’t touched interest rates YET – they say it is just around the corner though.. Do you understand the risk yet? Have you connected ALL the dots?

It’s clear that the days of cheap money are long gone..

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