Why the housing market is now almost entirely at the mercy of the bond vigilantes

Understanding the Mortgage Qualifying Rate

I apologize in advance for a short post. I want to highlight a great article over at Move Smartly in which the author nicely explains the Mortgage Qualifying Rate.

Basically, since April of 2010 when Flaherty first tightened mortgage rules, people hoping to take advantage of a much cheaper variable rate mortgage must qualify at a new mortgage qualifying rate (MQR).  So while the 5 year variable mortgage at most big banks is currently a ridiculously low 2.25%, the actual amount of mortgage that a borrower is approved for is not calculated using that low figure.

Rather, it is now calculated using the MQR which is essentially the posted 5 year fixed rate at the big banks.  As a quick explanation, the posted rate is what is advertised by all banks, though overwhelmingly the actual rate you *should* receive is significantly lower.  This is known as the discount rate.  If you pay the posted rate, you are a sucker!

The net result of those mortgage rule changes was to make it actually easier to qualify for the 5 year fixed rate.  In other words, a new home buyer will now be approved for a larger mortgage if they apply to take out a fixed rate mortgage.  Move Smartly actually did a bit of the math:

Let’s use an example to show how the MQR works. Assume that you are applying for a $300,000 mortgage amortized over 25 years, and that the current rates offered are as follows:

Five-year variable rate = 2.25%
Five-year fixed rate = 3.99%
Mortgage Qualifying Rate (MQR) = 5.44%.

If you want to borrow at the five-year fixed rate, you must pass the lender’s income tests using a monthly payment based on 3.99% (which using the example above is $1,576).

If you want to borrow at the five-year variable rate, you must pass the lender’s income tests using a monthly payment based on 5.44% (which is $1,820) even though your actual monthly payment would be only $1,306 (based on 2.25%).

In other words, if you want a variable-rate mortgage you have to prove to the lender that you can afford for variable rates to rise more than 3% over the next five years. And if you want a fixed-rate mortgage term that is less than five years, the test is the same. You must show that you can qualify using the MQR rate of 5.44%, even though the actual rate you are paying will be lower.

The big question then becomes, why hasn’t this had more of an effect on the market?  The answer to that is to look at the movement in the yield of the 5 year Government of Canada bond.  Movements in fixed mortgage rates track the movement in the 5 year GoC bond yield.

In other words, when bond yields rise, fixed mortgage rates rise also.  Variable mortgage rates on the other hand are based on the overnight rate at the Bank of Canada.  This is becomes paramount when we look at the movement in yield on the 5 year GoC bond since the April rule changes took effect, we note that yields have generally fallen:

We live in a world where the dual concerns of rising inflation and weakening government balance sheets can raise their heads at any time.  We are now overwhelmingly at the mercy of the bond market to sustain house prices at extreme levels of valuation.  It’s not a good situation to be in.  With interest rates facing an inevitable march upwards and with new mortgage rule changes set to further drain the dwindling buyer pool, house prices face significant headwinds moving forward.



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17 Responses to Why the housing market is now almost entirely at the mercy of the bond vigilantes

  1. Mac Sweet says:

    great blog ben, been following this and garth turner’s for some time now. my wife and I are thinking of buying a house in the low-end of the market (mid-$200K) in the grimsby, ontario area. we plan to stay for the longterm, can put 20% down and don’t want to amortized more than 20 years. i’m thinking 10 yr fixed rate, fixed over variable is my preference because I worry about interest rates having nowhere to go but up.
    question: what would be the better choice > 5 yr or 10yr fixed rate OR chosing a variable rate ?

    • Leo Lee says:

      Mac.. If you can afford the higher fixed rate and very short amortization payments, I would recommend that you go with variable rate. You should be able to get a P-0.80% (or even -0.90%) if your qualify. But find a lender who will allow you to fix your payments at a higher level as if you were paying a higher fixed rate mortgage. That way, your Mortgage Freedom Day will come that much sooner.

    • rp1 says:

      I second the variable rate over fixed if you can pay it down aggressively.

  2. LightsOut says:

    Good blog, I also follow you every day.

    My point of contention is however long term interest rates:

    Everyone, and I mean absolutely everyone, thinks that interest rates have to move up. This is a very crowded trade. The rationale seems to be that they move up and down in generational cycles and that the next move just has to be up. I haven’t seen anything else advanced as a reason, that is worth discussing.

    A few points:

    1. If rates stayed low for another ten years they would not violate long term trends.
    2. What exactly will drive them up? You have to have a mechanism that can ratchet inflation expectations (ie prices rise, buying power rises to meet them, rinse and repeat) – one time effects such as we are seeing now will not do it. There are really only two conditions that can do that. One is a tight labour market and the other is very large and sustained increases in imports (ie oil) due to structural changes such as scarcity – these are the 2 biggest contributors to companies bottom line costs. Maybe in a few years oil will do this – thats a bet I’m willing to take but its the smaller of the 2 effects. On the other hand you have a pending cutback in credit that is historic and overwhelmingly cutting demand at the margins. When the politicians get over their deficit fantasies this will hit full force.

    • Hi LightsOut

      I happen to believe that interest rates will stay low for a longer period of time as deflationary pressures remain intact. But the end game is still higher interest rates…..eventually.

    • jesse says:

      Lower rates mean lower wage growth. It looks as if borrowers expect a perpetual free lunch: low rates and wage growth. I argue this is not realistic. If total wage growth picks up, bond yields will rise.

      • LightsOut says:

        Agreed……if they pick up sustainably, but what are the chances of that?

        In the US wage growth is stagnant..has been for a long time.
        Corporations have been showing reasonable earnings mainly through cutting labour and foreign earnings.

        Labour has no pricing power. Delevering has just begun, austerity is the new trend. Thats not an environment for sustained wage increases.

        Canada is different to an extent but we cant have rates wildly out of kilter.

      • jesse says:

        Yes but what does that imply for prices? Anaemic wage growth eventually puts significant pressure on rents and prices. This is a delayed effect since it takes years for people and gov’t’s to figure out there is no more money.

  3. Liam from Calgary says:

    With interest rates facing an inevitable march upwards
    Ya Right !
    Three more Canadian lenders say they will lower some of their fixed rate mortgages as nervous investors move to bonds, causing a drop in long-term interest rates.

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