As we all know, real estate financing plays an integral role in the affordability of real estate to most Canadians. In fact, every 1% increase in residential mortgage rates literally ends the dream of home ownership for thousands of Canadians. When these rates play such an integral role in the availability of housing for Canadians, how is it that so many people have so little understanding of how these rates and mortgage pricing models are arrived at?

The mortgage market is definitely a segment unto itself in the financial marketplace. Still, to understand what is occurring in the mortgage market, one must understand how it interacts with the overall market for funds, commonly referred to as the capital market. The very cornerstone of the capital market is simply this: at any one point in time, some segments of the economy have surplus capital (investors) while others in the economy have a use for that surplus capital (borrowers).

The Capital Market

The capital market, as it is defined, refers to the market that facilitates the transfer of funds from those who have excess to those in need (savers to borrowers). One of the largest determining factors of the supply and demand for funds is the interest rate that governs the process. This provides a measurement for the reward of saving, while providing the cost of borrowing. The equilibrium interest rate is the point where there is a close balance between the amount borrowed and the amount saved. In economic terms, the interest rate is the point where there
is a close balance between the amount borrowed and the amount saved. In economic terms, the interest rate is the "price" of borrowed money.

The Mortgage Market

In the past, banks primarily lent mortgage money from the deposit base of their customers. In today's market this is increasingly no longer the case. The competition for deposits has now escalated to the point where there is no longer a sufficient deposit base for banks and trust companies to lend from. Today, much of the bank’s lending capital comes from their own ability to borrow from the debt capital market.
The debt capital suppliers have the primary responsibility of making sure that they preserve the capital of their investors while getting a fair rate of interest for the money they lend based on what it is lent for. The key driving forces behind the cost of that money (interest rate) is the relative creditworthiness of the borrower coupled with the expected rate of inflation for the period of time the money is being used.

Mortgage Pricing

As always, the risk return trade-off holds true in the marketplace. In order to lend money out to higher risk areas, the debt capital suppliers must be able to command a risk premium (extra return) for enduring that risk. This premium is factored in through a higher interest rate.
So how are almost perfectly secured investments like prime residential mortgage rates priced the way they are? The comparison is really quite simple. Commonly in the financial markets, government backed financial instruments serve as the entry point being viewed as the risk-free investment. That is to say, governments have almost zero default risk through their ultimate ability to increase our taxes and control money supply (among many other variables).

In this case of mortgages, that comparative instrument is the federal government bond. This bond represents a promise by the Canadian Government to pay the interest stated and to repay the original capital at the stated maturity date.
Today, the largest determining factor is the relative price of the government bond for the term of the mortgage selected. In order to encourage those who invest in debt capital to invest in mortgages instead of government bonds there must be some kind of premium given as a reward for the extra risk associated with investing in mortgages.

This risk in financial terms is referred to as the spread. The spread effectively determines the premium charged for investing in mortgages instead of government bonds. This spread must take into account all of the extra costs incurred to fulfill a mortgage portfolio, and it must also factor in a profit. What you will find is that these spreads generally remain fairly constant.

So, next time you want to predict a mortgage rate movement, spend less time watching the Bank of Canada and more time watching the movements in the bond market. While the bond market does trade on expectations, it is important to note that these expectations are typically the key driving force behind the mortgage rates we face. By tracking the day-to-day movement of these rates in the financial markets you may have much better success at predicting which way mortgage rates will move next.

_{This Article originally published in "New Homes and Condos - GTA" in the Oct 13, 2003 - Oct 27, 2003 and Apr 14, 2003 - Apr 28, 2003 issue.}

Calum Ross is one of Canada’s top ranked mortgage advisors. He has appeared on Canada AM, Investment Television, Report on Business Television, City TV, is an industry speaker and mortgage columnist. He holds both a B.Comm and MBA in Finance.