The Long and Short

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I was never a finance major, so it comes as a bit of surprise to me to learn how little business and finance students actually understand about interest rates and how a bank sets them.    To be fair, a lot of our misconceptions about interest rates and banking comes from the media.  How information is delivered to us influences our perceptions and makes us believe the stories that we read in mass media.  The underlying facts; however, remain the same, and if you care to educate yourself then the truth can be yours.

To begin let’s keep it very simple.  What does a bank do?  And no, they aren’t here to rob you despite what all your water cooler friends are saying.  Deep down to the root of it, the bank provides a service.  The service is quite easy to understand, they take savings from people and then lend it out to parties that need money.  The bank acts as an intermediary in the exchange of funds and in the process of being a middle man, the bank takes a fee from the borrower for the services.  Of course no one just gives money for free to anyone, so the bank provides incentives to savers by giving a small fee back to them.  In order for the bank to make money, it makes sense that the money they give to savers is less than the money they take from borrowers.

You might ask then why shouldn’t I make the money instead by lending out my money instead?  Well think of it this way.  Suppose an individual wants five dollars.   No one has five dollars, but five people have one dollar.  As a bank, you would take the one dollar from the 5 individuals and promise to pay them back one dollar and one cent back.  Now the individual that needs five dollars can borrow from the bank, but they must pay back the bank an extra ten cents when the five dollars is returned.  The five cents represents the profit of the bank.  The bank works at larger economy of scale, and thus it is able to leverage it’s service to provide larger loans to individuals.  I’m sure we can all agree, that we each don’t have $100 million dollars to loan to General Motors if they asked for it.

Now that we understand how a bank works, how does this affect my interest rate?

When you deposit money into your savings account at the bank, the bank returns your good will by providing you interest on the money you deposit.  The interest rate that the bank pays you is tied closely to the Bank of Canada’s prime lending rate.  That rate is sometimes called the overnight lending rate because it essentially represents the daily interest rate paid for loans.  Since you can take your money out of the bank at any time, the bank has very little time to put that money to work.  In essence, the Bank of Canada’s prime lending rate is tied to the bank’s short term loan interest rates.  These short term rates could include investment loans, short term (1 or 2 year) fixed mortgage rates and variable mortgage interest rates.  So if you were to make a relationship between the Bank of Canada’s prime rate and your mortgage, then the prime rate will only affect your mortgage rate if you are on a short fixed term mortgage or if you have a variable mortgage.

So how does this affect 5 year fixed mortgages rates that the banks push so hard to sell?  Well, the truth is, these rates are not as strongly affected by the Bank of Canada’s prime rate as they are from long term treasury bond rates.  Yes, that’s right, you’ve read it right.  Long term fixed mortgages are actually affected by government bond yields.  In Canada, the best gauge for long term rates is the 5-10 year Canadian Bond.

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The above chart, courtesy of the Bank of Canada, shows how yields have changed over the past year for 5-10 Government of Canada bonds.  The reason why banks have risen interest rates from a low of 2.59% to the current 3.59% for 5 year fixed rate mortgages is because the yield on Canadian bonds has risen by almost 1% in the past year.   Banks need to raise capital in order to lend money out to individuals or families for mortgages.  Contrary to what you may think, the bank doesn’t print money in the vault.  The bank needs to sell bonds of their own to raise capital and the buyer of bonds are individual savers who are seeking low risk investments that pay a yearly interest.  In order to remain competitive in the bond market, banks sell bonds at an interest rate just above the interest rate of bonds issued by the Canadian government.  In order to make money from your mortgage, they therefore need to raise interest rates above the interest rate that their bonds pay.

So how are the interest rates from bonds issued from the Government of Canada determined?  Quite simply whatever the market conditions will bear on the stock market.  Canada Bonds are traded freely on the stock market.  So your 5 year fixed rate mortgage is essentially controlled by stock traders and brokers.  Isn’t that scary?

This doesn’t mean you should quickly switch over to a short term mortgage or a variable rate mortgage.  If you are a home owner, or you are considering purchasing a home, you should be fully aware of how interest rates are set so that when you negotiate your mortgage with a broker or a bank, you have full knowledge of how your decision on the type of mortgage you get can be influenced by external factors.  When picking variable and short term rates, pay close attention to what the Bank of Canada is doing with its prime rate.  If you are choosing a longer term rate, how is the bond market behaving for your country’s treasury bonds?  Are they rising or are they falling.  If you are trying to determine what interest rates will be when your mortgage comes up for renewal, closely follow the policies of your central bank and watch for trends in your countries treasury bonds.  Most important of all, don’t ever assume that the interest rate for your mortgage will stay the same forever.

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