Trevor Dale, CFA gave a presentation to iBridge Capital about the flow of mortgages and what happens after they are funded. It’s one thing to get a mortgage however how does prepaying your mortgage work, how does insuring the mortgage through CMHC or Genworth affect it and how does the economy affect you mortgage and mortgage rates?

Note: all mortgage advice is provided by Trevor Dale, Mortgage Agent, iBridge Capital Inc. #13506

Trevor discusses how the whole purpose of a lender is to keep lending. A lender has a theoretical limit on how much money they have to lend out. When they have lent out all of their money they have a choice. Wait until the money is repaid in order to lend it out again or they can package them up and sell them off. 

The lender then gets paid for the package of loans/mortgages and then they can loan out the money again. Once that money is lent out then they can repeat the process of packaging out the loans again.

This is the process of originating and servicing loans. The process just described is the process of originating. They are creating loans with houses as collateral which is called a mortgage.

Servicing a mortgage is when the payments and accounting are done for the mortgage. This could also include paying the property taxes on behalf of the property owner and sending out annual mortgage statements. Servicing also includes dealing with prepayments and renewals.

These pools of packaged loans get broken up into tranches of which there are varying types of risk. These are called mortgage backed securities. The first tranche is usually the largest and will be the first recipient of any prepayment of mortgage. The second and third tranches receive prepayment after the higher tranche has been repaid.

The first tranche therefore has higher prepayment risk however assuming an even mix of mortgages, they would have a higher credit risk due to being in existence longer.

Prepayment risk is when a mortgage backed security is either prepaid sooner than expected or extended due to a lack of prepayments.

Prepayment risk comes in numerous forms.

  1. Change in mortgage rates
  2. Housing turnover
  3. Underlying mortgage loans
    1. Seasoning (plateaus)
    2. Geographical location (housing turnover)

A decrease in mortgage rates can cause contraction risk where the mortgage backed security is repaid faster than expected as borrowers switch lenders to take advantage of lower rates. This poses the mortgage backed security that gets prepaid and now has to reinvest at the lower interest rate.

An increase in mortgage rates can cause extension risk where a mortgage backed security is held on longer than anticipated and rather receiving the money back to reinvest at the new higher rates, they are force to stay in the mortgage backed security unless they sell the bonds.

Prepayment penalties help to reduce this risk and discource an investor from repaying their mortgage. It makes the hurdle for being economical to move lenders higher as there is a cost to break the terms of the mortgage.

Most lenders charge either a 3 month interest penalty or an interest rate differential penalty.

The interest rate differential penalty, or IRD for short, is calculated off of the remaining term on the mortgage and the difference between the current rates and either the rate that was used for the mortgage itself or the posted rate at the time which is almost always higher than the actual mortgage rate.

Many banks charge IRD off of the posted higher rate whereas many “mononline” lenders use the contracted rate which was the rate that the actual mortgage has.

Housing turnover nationally can play a role as in a market that is growing and has lots of turnover will cause a higher prepayment of mortgages as people move houses and sometimes lenders.

The underlying mortgage loans themselves can also have an affect as there is very little prepayment usually in the first year and the prepayment in the subsequent year rise until they typically plateau.

It is thought that around 66% of mortgages last an average of 3 years and don’t make it to a full 5 year term. Closer to the end of the term will be an incentive to wait until maturity before changing mortgages. Patience become more palatable.

Mortgages for variable rates are priced off of the Bank of Canada overnight rate plus a spread that the lender puts on. This will fluctuate with changes to the rate or anticipation. Not all changes in the rate will cause the mortgages rates to be affected. After 2009 lenders started to add a larger spread to maintain profitability.

Fixed rate mortgages are derived from government of Canada bond rates plus a spread. Bond rates are based off of interest rates and economic expectations. Note that I said expectations, not the actual economy. An anticipation of a worsening economy can cause bond rates to fall and fixed mortgage rates may follow suit.

A strategy to take advantage of a lower variable rate would be to take out a variable rate yet base the payments as if you were paying a higher rate. This reduces the risk that you may not be paying enough interest should interest rates rise and it also pays off the mortgage faster which further reduces the principal amount which in turn reduces the amount of interest charged. Should rates stay the same or decrease then you will be better off with a variable rate.

Particulary if you plan to move but don’t know when. Most variable rate mortgages only have a 3 month interest penalty which is most often considerably smaller than an IRD. This provides flexibility, a lower interest rate and the ability to pay the mortgage down faster.

Until next time,

Trevor Dale, CFA