A month ago, I tested a theory that only people who have mortgages truly understand what they are. The same, I believe, is true for interest rates. We know it’s the price we pay for getting a loan and that we want the lowest rate possible — but do the majority of us actually understand what’s behind the percentage?

Interest rates are the grown-up equivalent of kids asking where babies come from. They show up one day (when we buy a place) but there are some major plot holes. Who decides what the interest rates are that day? How are they calculated? Should I get a variable or fixed mortgage rate? When do I start paying off the actual loan, instead of the interest? The more I learned about interest rates, the more I felt like David at the dentist.

With the help of Toronto-based mortgage agent Lisa Okun, we’re breaking down WTF interest rates actually are, how they affect your pocketbook over the life of your mortgage, and where they come from (spoiler alert: the answer isn’t storks).

Photo: LendingMemo.com

Let’s start at the very beginning. WTF is a loan?

Borrowing money is great but there’s always a catch: interest. For mortgage loans, the interest rate is applied to the principal — the amount your lender gives you after you contribute the downpayment. For example, if you bought a condo for $500,000 and put down 20 percent ($100,000), the interest would be applied to $400,000 (the principal). Then you sign a contract agreeing to pay it back by a predetermined date. This is your amortization period (which can range from 6 months to 35 years) in periodic installments (most people make mortgage payments every month).

Your first mortgage payments will be interest-heavy. As your loan’s principal goes down over the years with more payments, so too does the interest you’ll pay on it.

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Interest rates will not stay the same over the entire life of your loan. When a lender gives us a loan, we are contractually bound to them for the “term” — the length of time you commit to the interest rate, lender and associated conditions. Term lengths can range from 6 months to 10 years, and gets renewed — either with your current lender, or you shop around for another one — after the term period is over. With shorter term lengths, you get access to lower rates.

“There are more competitive rates if you take a shorter term, usually. But you’re putting yourself in a riskier position because if you take a two year term, at the end of it, you don’t know what the rates are going to be,” says Okun. “The reason the banks push these better rates with shorter terms is because they expect the rates to go up in two years and they’ll be able to roll you into a higher rate. If you had just taken the five year rate at the outset, you would have probably been in a more advantageous position at the end of it.”

Photo: James Bombales

Who decides what the interest rates will be?

Mortgage rates will rise and fall over the life of your mortgage. Larger economic factors generally determine if they’re low or high. Interest rates decrease when dark clouds settle over the economy. Whether it’s insecurity in a foreign market, rising unemployment or an asset bubble popping, you can expect these economic forces will cause an interest rate rollback. In Canada, lending rates bottomed to historic low levels during the financial crisis in 2008 caused by the US housing bubble popping. Mortgage rates increase when the stock market is strong, foreign markets are stable, and jobs are plentiful.

“For the last few months — which is the first time in quite a few years that this has happened — rates actually started to go down. It’s been an environment of rising interest rates for at least a year,” says Okun. “That’s based in part on the Bank of Canada’s assessment of how the Canadian economy is doing, which is related to all sorts of things: our oil industry, our relationship to the United States, our housing market and so on.”

The Bank of Canada uses this information to set the prime rate (otherwise known as the prime lending rate), which Canada’s major banks use to set interest rates for variable mortgages and other loans. The prime rate is primarily influenced by the Bank of Canada’s overnight rate — the interest rate at which banks borrow funds from one another overnight. What you need to know is this: “The Bank of Canada reviews the overnight rate eight times a year. When the overnight lending rate goes up, the prime rate is probably going to go up too. If you have a variable rate mortgage, that’s the announcement you’re going to be looking for,” says Okun.

Photo: Austin Distel on Unsplash

WTF is the mortgage stress test?

In January 2018, new mortgage rules were introduced that require all Canadian homebuyers to take a stress test in order to qualify for a mortgage from a federally regulated lender — this usually means one of Canada’s five major banks.

“With the stress test, you get your contracted interest rate and that is the rate that you’ll be paying. But now, the lender needs to know that you could theoretically afford your mortgage at a higher rate — either two percentage points higher than your contract rate or the Bank of Canada’s benchmark rate (which is currently set at 5.34) — whichever is greater.”

Okun breaks down an example: “Right now, rates are kind of low. We’re seeing rates around 3 percent or a little higher. So they will have to stress test against the benchmark 5.34. But if you have a rate that’s 4.99, you will need to qualify at 6.99.”

There is a small difference if you’re contributing a downpayment less than 20 percent. You still have to qualify at the Bank of Canada’s benchmark rate, but in the event your interest rate is higher, you will be exempt from adding the two extra points. With interest rates being where they are right now (at the time of writing), virtually everyone is being stress tested against the Bank of Canada’s benchmark rate — regardless of your downpayment size.

Photo: James Bombales

Not everyone has access to the same interest rates.

The Bank of Canada is driving the car when it comes to interest rates, but you’re along for the ride, too. Things like your credit score, debts, downpayment amount and the type of mortgage you get will impact what interest rates are available to you.

“There are different interest rates if you’re getting an investment property versus an owner-occupied property, if you’re planning to buy a second home versus your primary residence, if you’re getting an insured mortgage versus an uninsured mortgage — there are all sorts of different programs out there,” says Okun.

If you put down less than 20 percent, you default to an insured mortgage and get access to lower rates. This is because you’re paying a hefty insurance premium to CMHC, meaning that if you were to default on your mortgage, your lender would be off the hook. Less risk for your lender, lower rates.

It doesn’t seem fair to be penalized with a higher interest rate when you’ve worked so hard to save for a downpayment over 20 percent. But even though the rates appear more attractive for an insured mortgage, people always end up paying more monthly. This is because they’re getting dinged with the insurance premium. In addition, their downpayment is smaller, so they’re usually paying interest on a larger loan.

Your credit score is also key. “If it’s above 680, you have access to the best rates,” says Okun. But with lower credit scores, lenders actually add a predetermined amount of basis points to your interest rate depending on the range you fall in — making the rate climb.

Rates also vary from lender to lender — which is why it’s important to shop around. “Every lender structures it differently, so finding the one that works best for you is really a matter of working with someone who understands what you’re looking to do and can do the shopping for you,” says Okun.

Photo: James Bombales

How long will it take you to pay it off?

The sooner you pay off your loan, the less interest you’ll pay in the long run.

“The longer your amortization period, the lower your monthly mortgage payments are going to be because you’re stretching your mortgage out over, say, 30 years instead of 25. You’re going to get the lowest possible monthly payment at 30 years but you’re also going to be ultimately paying more interest because you’re doing it over a longer period of time.”

Okun recommends taking the longest amortization available to you because you can always expedite it with lump sum payments or prepayment privileges. This way, if you ever find yourself in an unsavoury financial situation, you can stretch your payments to the maximum amortization and get some relief.

Are you getting a fixed or variable mortgage?

If you get a fixed mortgage, the rate you settle on will be your rate for the entire term of your mortgage. A variable rate is going to fluctuate based on what direction the prime rate is moving in.

“When you get a variable rate, you get a discount on the prime rate. Depending on the discount, it could be prime minus 95, prime minus 35, prime minus 1.05. As prime fluctuates, so will your rate. If prime happened to go down, you would still get that discount.”

At the time of writing, prime is at 3.95 percent for most lenders. So if your variable rate was prime minus 95, your interest rate would be 3 percent. If prime increased to 4 percent, your discount would hold steady and you would pay 3.05 percent.

Historically, variable rates tend to do better. “With a variable rate, there is often an opportunity to save money, but you have to be comfortable with some risk,” says Okun.

Photo: James Bombales

Do interest rates affect home prices?

The answer is yes and no. “If you look back historically at what interest rates were 30 years ago, they were a lot higher and home prices were a lot lower. Usually when rates go up, home prices go down a bit,” says Okun. “Obviously, it depends where you’re looking. We’re in Toronto where prices are pretty inflated as it is and then there are some neighbourhoods where home prices just go up regardless of what’s happening with interest rates. It depends on supply and demand.”

When mortgage rates are higher, people are less likely to list their homes and sign on for a new mortgage. “People have to move somewhere,” says Okun.

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