Why Are Mortgage Rates Rising?

People are living longer than ever before, a phenomenon undoubtedly made necessary by the 30-year mortgage.

~ Doug Larson

Update: This article was included in the Carnival of Financial Planning #136 posted at Bargaineering. Thanks!

On Monday, several Canadian banks boosted their fixed mortgage rates by 60 basis points (.60%). That’s a pretty big hike all at once. The Globe and Mail ran the following headline: Mortgage Rate Boost Signals Rock Bottom Era Is Over. Can’t you just hear all those folks who just signed up for variable rate mortgages scurrying to lock in fixed rates?

We had to renew our mortgage a while ago when rates were higher and currently have a 5-year 5.49% rate. Unfortunately, (or fortunately?) it’s not as easy to renegotiate mortgages in Canada as it is in the U.S., so we have tried to do the only thing we could: pay it off faster. That 5.49% rate is higher than a GIC and safer than the stock market.

How Are Mortgage Rates Set?

Mortgage rates are determined by a number of factors. Those factors can be different, depending on whether you’re talking about a fixed rate or variable rate mortgage. Let’s take them one at a time:

Fixed Rate Mortgages: These rates are generally determined by the bond market. If the yield on a 5-year government bond has recently risen, chances are you will see a similar hike in 5-year fixed mortgage rates.

Variable Rate Mortgages: These rates are determined by the Bank of Canada target for the overnight rate. That’s the announcement we get every month or two at 9 A.M.. You’ll generally see it reported in the business news, unless something unusual is happening (as has been the case over the past couple of years). In that case, it might make the headlines in the mainstream media.

In general, central banks have greater control over short term rates, whereas bond traders have more control over longer term rates. You can read more about the mechanics of the bond market in Where Are Interest Rates Going?

What Caused Monday’s Mortgage Rate Increase?

According to the Globe article cited at the top of this post, 5-year Canadian government bonds have risen .25% since February, caused by improving economic data and nascent inflation fears. But why has a 25 basis point boost to government yields translated into a 60 basis point hike in mortgage rates?

I’m no expert on these things, so I would love to have some input from those who know better than I. Nevertheless, I have a theory. There were a couple of U.S. bond auctions last week that didn’t go as well as expected. That means that bond buyers demanded higher than expected rates as compensation for their investments.

The unsightly fiscal situation south of the border is well-documented, but they have been able to finance their burgeoning debt quite easily up to this point. It could be that the market is beginning to experience the indigestion that I’ve written about in the past, or it could be that China is sending the U.S. a subtle warning.

Last week, there were protectionist rumblings by some U.S. politicians who think that the U.S. should exert more pressure on China to revalue the yuan (the Chinese currency). Scholars of the Great Depression know that protectionism was one factor that deepened and prolonged the economic turmoil of the 1930′s. Read John Mauldin’s latest letter for some thoughts on this as well as an answer to the question What Does Greece Mean to You? At any rate, I doubt that China appreciated this protectionist pressure and they may have been tepid in their bond auction participation as a result.

What Are the Implications of Higher Mortgage Rates?

According to Benjamin Tal, as quoted in the Globe article: “while interest rates are at historical lows, affordability, or consumers’ ability to cope with their debt is not.” Interest rates have been low for a very long time and that has lead many consumers to take on more debt, both in terms of mortgages and consumer debt.

Many Canadians are already maxed out in terms of spending and debt. If rates were to rise, that could just be the tipping point for a renewed economic crisis. High unemployment and underemployment levels only exacerbate the situation.

The Globe ran another article on Tuesday that cited a new Conference Board of Canada study that said Many Struggle to Afford Their Homes. According to the study, about 20% of Canadians are having a hard time keeping up with the cost of their homes. Housing costs were considered unaffordable if they exceeded 30% of pretax income.

Can’t the Central Banks Just Lower Rates Again?

Well, not really. If they were to raise rates at some point and then choose to lower them again, that would be a possibility. But at the moment, short term rates just can’t go much lower. Complicating matters further is the fact that, as mentioned above, central banks don’t have much control over the longer term rates that determine fixed rate mortgages. Let’s hope the bond vigilantes don’t decide to kick up a fuss anytime soon.

Many pundits have contended that a massive wave of inflation will eventually head our way as a result of loose monetary policy and lots of money printing. While I think they are on the right track, I don’t think that inflation will be the reason rates rise in the near term. In fact, I think we may be in for some debt deflation first.

Again, I’m no expert on this. I’m just thinking out loud. I’m wondering if it’s possible that we could see a deflationary environment coupled with rising rates at the long end of the yield curve. In this scenario, rates would rise due to a lack of appetite for bonds rather than as a result of inflation.

Once I start thinking in these terms, I get dizzy pretty fast. I would love to hear some ideas on this, as I’m not sure if it’s even possible, or if there’s any precedent for such a scenario. Normally, deflation is associated with lower rates if I’m not mistaken. Would renewed economic trouble lead rates lower, or will bond traders take them higher based on global fiscal problems?

Can anyone shed some light on this for me? Is it possible to have rising rates during a deflationary period?

Are you prepared for an increase in interest rates? How will it affect your household?