Tuesday, September 18, 2007

Why are Adjustable Rate Mortgage rates on the incease?

Please be aware that there is significant pressure to increase interest rates on Adjustable Rate Mortgages.

The current pricing environment of rates as low as Prime -.90% may not be available for much longer. Some ARMs in the market have already changed to Prime -.50%, a 40 bps increase and I would like to take this opportunity to explain what is happening in the markets today that has caused this shift in product pricing.

In layman's terms, what is happening?

Adjustable Rate Mortgages are typically priced according to the current 30-day Banker Acceptances (BA), which are a very common short-term money market investment, guaranteed by the banks. A lender funding adjustable/variable rate mortgages would typically borrow money through a 30-day Banker's Acceptance. The lender is then responsible for paying the yield (rate of return) to the investor who purchased the BA. This yield is the cost of funding mortgages ("Cost of Funds") to the lender.

So, what's happening to the BA yields?

This is where the story has become interesting over the past few months.

The failure of the U.S. subprime market worried money-market investors. In Canada, investors began to sell off investments creating a strain on the market. Those who remained demanded higher yields from the BA market as no one was sure as to how much of these BA's were used to finance U.S. subprime mortgages, or subprime mortgages here in Canada or other risky ventures. Everyone was asking the same thing: What's the risk exposure? A classic example of the market overreacting.

The resulting increase in BA yields increased the cost of funds for lenders who want to finance their Adjustable Rate Mortgages. Essentially it's costing lenders much more money now to finance ARMs than it did 60 days ago.

The following is a comparison of 30-day Banker's Acceptance yields over the past 60 days:

July 17, 2007: 4.54%
August 3, 2007: 4.60%
August 14, 2007: 4.75%
August 17, 2007: 4.92%
September 11, 2007: 4.98%
September 17, 2007: 5.04%

*Source: Bank of Canada (http://www.bank-banque-canada.ca/)

So, in 60 days we've seen the yield on 30 day BA increase 50 bps.

Now consider the interest rate earned by the lenders on an ARM at Prime - .90%. Today that interest rate is 5.35%. When you compare this to the current Cost of Funds at 5.04%, which doesn't include overhead, profit margin, one can see that it's only a matter of time before prices for ARMs need to change.

How long will this continue?

Are we seeing the end of the days of Prime - .90%? Perhaps for a while, until the money markets settle down.

The silver lining in all this is that due to Canada's continued economic expansion and the reality of an $80+ barrel of oil, our longer term bonds are in high demand. As a result, we might see some interest rate decreases on the fixed rate products.

If you wish further information on how to protect yourself against further increases in rates contact the Ontario Mortgage Team Professional nearest you.


Anonymous said...

Isn't this taken directly from Firstline's email to mortgage brokers last week?

Dave Yeoman said...

Unfortunate that you did not identify your yourself rather then remain anonymous as I would have liked to address you personally. No the information is provided with the kind premission of Merix Financial not Firstline.

Ontario Mortgage said...

why would they want to increase the interest rates? won't this slow down the selling of property in canada? I hear that the real estate industry there is booming now?

Melissa said...

Many people today are in a lot of trouble because their mortgages have adjusted to a higher interest rate, causing their monthly payments to rise. At the same time, the value of their house has fallen and can't be sold quickly. Some people are in a position where the debt owed on their mortgage is more than the house is worth.
That's why I think if you want to protect yourself against ARM increase when it comes to your own home, it is almost always wiser to chose a fixed rate mortgage especially if you have poor credit and have to apply for bad credit mortgage option. Although interest rates on fixed rate mortgages can be higher for the first few years, they do not change throughout the life of the loan. If you choose a 30 year mortgage, your monthly payment will be the same for the next 30 years. This allows you to avoid unexpected rises in interest rates and puts you and your family in a more secure position.

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