Why are mortgage rates hitting record lows?

All across the country, mortgage specialists and brokers are busy fielding calls from people who've just heard about this week's record low mortgage rates.

Bank of Montreal made the biggest splash by announcing a five-year fixed-rate mortgage of 2.99 per cent – the lowest advertised rate for such a popular mortgage term by any major Canadian bank, ever.

Yes, there are more restrictions than usual attached to this mortgage and it's supposedly just a two-week promotion.

But other big lenders – like the Royal Bank – have already begun to match BMO's offer. TD Canada Trust and Scotiabank now have a similar interest rate for four-year fixed-rate mortgages and TD this week lowered its six-year fixed rate mortgage to 3.79 per cent – a drop of more than a full percentage point. It also lowered its seven-year mortgage by almost a full percentage point to 3.99 per cent.

So what's driving all these rate plunges at the chartered banks? 

One element is that bond yields have been plunging recently, so market watchers say it's not too surprising to see other rates drop, too, a reflection of there being more cash in the system.

"Mortgage rate declines have actually been lagging behind falling bond yields, driven by global economic uncertainty," says John Andrew, a real estate expert and professor at Queen's University's School of Urban and Regional Planning. So what we are seeing here is a bit of catch up on the part of mortgage rates.

It is the bond market that is the bigger driver of longer-term fixed mortgage rates, not the Bank of Canada's overnight rate, which directly affects variable mortgage rates and other floating loan rates.

With stock markets shaky and volatility reigning in the currency and commodity markets, nervous investors have been stuffing money into safe Canadian bonds – driving up prices and driving down yields.

The other reason cited by the experts is competition. "The first few months of the year are typically slower for the mortgage market," says Mark Kocaurek, the chief lending officer at ING Direct Canada.

In a commentary earlier this week for RateSupermarket.ca, he wrote that he expected lenders would lower fixed rates "over the short term in order to win more business." A couple of days later, they did just that.

Time to break your mortgage?

So if you belong to one of the estimated three million Canadian households that currently have a fixed-rate mortgage, you're probably wondering whether it's worth trying to get in on this super-low mortgage-rate action.

The bottom line from the experts: it depends.

For one thing, there's the penalty you pay if you do want to make a change.

The cheapest fixed-rate mortgages are closed mortgages – meaning that you can't escape the interest rate you agreed to pay for five years unless you pay the lender compensation for the interest it would lose by letting you switch from a higher interest rate mortgage to a lower one. 

There are two main variables that determine the prepayment penalty to get out of a fixed-rate mortgage early:

• The difference between your higher-rate mortgage and the current mortgage rate, known as the interest rate differential penalty; and
• The amount of time remaining in your mortgage's term. The longer the time, the bigger the penalty.

It's a complicated calculation – made all the more so because financial institutions have different ways of calculating penalties.

Some base their calculation of interest rate differentials on the posted rate (the current posted rate for a fixed five-year mortgage, for example, is 5.29 per cent – far above the actual 2.99 per cent lenders are now charging.) Some lenders, though, use their discounted rates to do the calculation.

If you want to switch, the only way to know for sure whether you'd be further ahead is to ask your current lender how much it would charge to release you early from your mortgage. 

Once you have that figure, it's a relatively easy matter for any independent mortgage broker to figure out whether it's worth your while to make the switch. Will the added costs of the prepayment penalty, and other costs that might be involved, be covered by the much lower payments over the next five years?

A good broker can also explore other alternatives to lessen the blow. For instance, some lenders eager to build market share may offer incentives that would cover much of the penalty.

By the way, those penalties can be huge.

"Fixed rates are attractive to people because they want to avoid risk, but one of the biggest risks you can have is the interest rate differential (IRD) penalty," says Aaron Vaillancourt, principal broker at Centum Engage Mortgages in Toronto.

"The penalty can be as much as the realtor fees," he says, sometimes even more. Vaillancourt says he has one client with a $290,000 mortgage who is facing an IRD penalty of $32,000.

There's no question that low mortgage rates are great for first-time buyers or others whose mortgages are now just coming up for renewal.

But some economists warn that these low rates will do nothing to keep a lid on what's been called an "overheated" real estate market in a few Canadian cities.

Others point out that the added restrictions on some of these 2.99 per cent mortgages –  such as no amortizations longer than 25 years – will help to keep out the barely-qualified.

What there's no debate about is that low rates have already saved Canadian borrowers billions of dollars.

The Canadian Association of Accredited Mortgage Professionals estimated recently that the 1.35 million mortgage holders who renewed their mortgages in the past year saved an average of $2,000 a year in interest costs – or $2.7 billion a year in total.