Federal Government Policy
The federal government, through the Bank of Canada (Central Bank) sets the prime bank rate. This is the rate that the central bank charges on loans to financial institutions. The rate is set each week, generally at 25 basis points above the average yield (interest return) on three-month treasury bills. The government auctions these bills weekly. 100 basis points represents 1 per cent interest, therefore 25 basis points would represent 0.25 per cent interest. Conventional lenders (banks, credit unions, etc.) adjust their prime rates and mortgage rates using the federal bank rate as a guide. The Central Bank rate therefore, sets a trend throughout the system.

There are various factors and political/economic dynamics which influence the federal bank rate.

• If the government is attempting to stimulate the economy because of a recession and lower the inflation rate, it may attempt to lower rates throughout the money system by lowering its bank rate. Conversely, if the economy is too buoyant and there is too much debt occurring, the central bank could attempt to increase the overall lending interest rates through increasing the Central Bank rate

•  Government treasury bills or bonds are sold to international investors, among others. These investors place their money where they believe they will be getting their best return on their money. The highest interest rate, relative to other federal government rates for bills or bonds, or for that matter provincial bond issues, will naturally be attractive. This is relative, of course, to the perception of the investor of the stability of the currency and the economic and political stability of the government and the country as a whole.

If there is uncertainty or concern in these areas - for example, the size of the national debt and current or project budget deficit - investors might get nervous. If the government wants to attract more investors, for example, it has to increase its interest rate for bonds. If there is weak demand for treasury bills because of financial market volatility,  that will affect the value of the Canadian dollar relative to the U.S. dollar and other currencies. For example, if the Canadian dollar depreciates ten cents relative to the U.S. dollar, then investors might expect a jump in interest rates to offset the net reduction in yield received by the investor.

All of the above factors influence mortgage short-term and long-term interest rates at any given time. This is why when you are getting a mortgage, for example, you may wish to have a six-month open mortgage if you think interest rates are decreasing, and then convert it into a three, five, or ten- year closed mortgage when you see that interest rates are heading up. This is just one of many considerations you have to take into account when determining your mortgage needs and selection. Other factors to consider are covered below.

Excess or Shortage of Supply of Money
There is a natural connection to the general economic cycle. When lenders have an excess supply of money to lend due to an inflow of customer deposits, for example, at RRSP purchase deadline time, then interest rates tend to be more attractive and competitive. This is because the lender needs to make money — that is, a “spread” on the difference between what it pays the depositor and what it charges for lending money. This spread could be 1 per cent to 2 per cent or more depending on various factors, including competition. Depositors must earn enough money on their savings to be comparable to the returns that they would earn on other investments, relative to the same degree of risk and liquidity.

Lenders realize that there is a high degree of consumer awareness to get the best rate. This is further reinforced by charts published regularly by daily and real estate newspapers comparing mortgage rates of various banks, mortgage companies, and credit unions. In addition, the Internet has many websites with interest rates and online mortgage applications for quotes.

The willingness of people to place money in a savings account is how a pool of mortgage money is created. A situation where the inflow of deposit funds is high and the interest rates are low, and the lender has funds to lend, is referred to as a “loose money” market. This affects the real estate market, of course. In this situation, real estate activity can be expected to increase because more people will be able to afford financing and purchase a home or other real estate investment. More activity in the marketplace means a dynamic of supply and demand, and real estate prices can be expected to rise.

On the other hand, if the public thinks it can get a better return on other forms of investment than deposit funds, in a low interest situation, for example, then the lenders are left with a shortage of money to lend for mortgage or other loans. This is referred to as a “tight money” market. The lender may reduce lending mortgage funds in many cases and be selective where the money is lent. Developers and contractors could have difficulty getting funds to build and, therefore, real estate activity slows down. As potential purchasers could have difficulty getting funds or may choose to hold off, real estate prices could drop due to the reduced demand. If mortgage interest rates are too high, many people may not be able to afford to buy as they may not qualify for a sufficient mortgage.

Type of Lender
Rates vary among lenders, depending on their policies and restrictions. A more conservative lender may charge a higher rate than another. In general terms, conventional lenders (e.g., banks, trust companies, and credit unions) tend to be fairly competitive in the rates they charge for mortgages. A private mortgage lender generally wants a greater profit and therefore will charge more.

Use of Mortgage Brokers
Mortgage brokers are licenced by provincial legislation. They know which lenders have flexible criterion for employed or self-employed borrowers, and which lenders have excess money and are motivated to lend out it out at attractive rates to earn interest. They also know which lenders might have incentives to borrowers at any given time, eg paying a certain amount towards legal fees, or covering any appraisals or surveys required, etc.

Quality of Borrower
Lenders assess the creditworthiness of the borrower and the ability to pay. A borrower who has few assets, has recently been employed or is self-employed, or has a spotty credit record, will pay a higher rate of interest than a borrower who has the opposite profile. For example, this is graphically reflected in the case of loans to a business. The lowest risk/no risk customer could receive the prime rate of interest (lowest) for a loan. Higher risk businesses could be paying prime +1 per cent to prime +8 per cent, if they can get any funds at all.

Quality of Property
After the lender has appraised the property, assessed the type of location and the resale potential of the property, and determined the amount of equity the borrower has, the lender will set the mortgage rate. Properties that are recreational, rural, speculative, or raw land might either be turned down or be approved at a higher interest rate. Frequently, in this latter situation, the lender will require higher owner equity and lower lender debt. Conversely, if the place you are buying is a house or condo in an economically stable community, you would probably obtain a competitive rate.

Priority of Mortgage
Basically, the security of the mortgage is greater depending on its date of registration relative to other mortgages. A mortgage that is registered first against the title of the property is referred to as a first mortgage, a mortgage that is registered second in line is referred to as a second mortgage, and so on. In the event that the borrower defaults on a mortgage and the property is sold, the first mortgage gets paid out first from the proceeds, followed by the second, etc. Therefore, the lower the mortgage ranks in terms of priority the higher the risk to the lender that it will lose money if there is a shortfall on sale. There is a direct relationship between risk and interest rate. A first mortgage could be at 6 per cent, a second at 9 per cent, and a third at 13 per cent. How much equity the owner has is also a factor. If the owner has lots of equity, no matter how many mortgages on the property, the lower the risk to the last lender of losing money on a forced sale.

Other Factors:
The mortgage interest rate is affected by many factors including the following:

• The amortization period (that is, the length of time the mortgage is paid out in full).

• Whether the mortgage is insured by CMHC or Genworth Financial Canada (if there is a lower risk, there is a lower rate).

• The length of the term before the mortgage is due for payment or renegotiation, eg six months, five-year term or longer. Generally, the longer the term, the more the risk of uncertainty about interest rates for the lender over that extended period; therefore, the rate is higher, as a protective buffer. This is not always the case, however.

• Whether the mortgage is open. If it is open, it can be paid at any time before the end of the term without penalty. If closed, it cannot be repaid or can be repaid but with a penalty, eg three months’ interest or interest differential for the balance of the term, whichever is greater. Open mortgages have higher interest rates; closed mortgages have lower interest rates.

• Whether the interest rate is calculated and compounded annually, semi-annually or monthly. The more frequent the interest calculation and compounding, the higher the effective rate of interest that you will be paying.

• The frequency of your payment schedule (e.g., weekly, bi-monthly, monthly, etc.).

For more information on mortgages, read my just released book “Mortgages Made Easy”.

Excerpted with modification, from 101 Streetsmart Condo Buying Tips for Canadians, by Douglas Gray, to be published by John Wiley & Sons in May, 2006. Copyright  2006 by Douglas Gray. All rights reserved. Any reproduction of this material without the author’s advance written consent is prohibited. The author assumes no responsibility whatsoever for any information provided above, as the purpose of the column is for general information only, and not intended to provide professional advice.

Douglas Gray, LL.B., is formerly a practicing lawyer in Vancouver, B.C., who morphed into a consultant, speaker, columnist, and author of 22 bestselling books, including the recently released Canadian bestseller, Making Money in Real Estate (The Canadian Guide to Profitable Investment in Residential Property), 2nd edition.  In his real estate legal practice, he has advised condo buyers and sellers, condo corporations, lenders, borrowers, investors and developers. He has also been a real estate investor for 35 years. His website is: http://www.homebuyer.ca.