What Determines Variable-Rate Mortgage Discounts?

Mortgage shoppers ask this question all the time. It’s useful information if you’re trying to discern variable rate trends.

While the answer is convoluted, below is some insight into how variable-rate discounts are formed and why they change.

Setting the Discount

Most of the time, lenders price closed variable mortgage rates at a discount from their prime rate.

There are two main factors that determine a lender’s variable-rate discount:

  1. That lender’s funding costs
    • Lenders fund floating-rate mortgages in a variety of ways (e.g., via deposits, bankers’ acceptances, covered bonds, mortgage-backed securities, etc.)
    • A rough proxy for base funding costs on floating-rate mortgages is the three-month banker’s acceptance yield
    • On top of that, lenders incur risk and liquidity premiums, overhead, compensation costs, regulatory capital costs, and so on
    • Risk and liquidity premiums are hard to measure on a day-to-day basis but can have a profound impact on funding costs (and pricing). Case in point was the credit crisis of 2008-09 when market risk and plunging demand for mortgage investments caused variable rates to be priced well above prime.
  2. That lender’s margin (profitability) objectives
    • It’s hard to measure a lender’s profit margin targets
    • One must compare its current rate and estimated funding costs to prior values of the same
    • Sometimes it’s clear when a lender decides to trade profitability for market share, as with BMO’s prime – 1.00% variable rate sale in May 2018.

When the Discount Changes

Most of the time, prime rate moves when the Bank of Canada changes its overnight rate. That’s easy to understand.

The discount to prime rate, however, is more of an enigma. It usually only moves significantly when there’s a big economic event that impacts bank funding costs or variable-rate profits.

Here are two recent examples:

  • In 2008 banks started slashing their variable discounts as concerns of default risk and funding illiquidity roiled credit markets (all stemming from the U.S. mortgage crisis). At the time, inter-bank lending rates soared. With recession risk growing, the cost of funds was actually increasing as the Bank of Canada was cutting rates. The liquidity premium investors demanded to fund variable-rate mortgages surged from less than 10 basis points to well over 50 basis points, practically overnight. Deposits were the most reliable funding at the time, so banks hesitated in slashing deposit rates in line with Bank of Canada rate cuts. Variable discounts therefore had no where to go but down. In October 2008, some of the big banks were advertising closed variables at prime plus 1.00%. By comparison, many of today’s lenders are at prime minus 1.00% or lower. Floating-rate pricing got so warped that in January 2009 the best 5-year fixed rates were priced below most variables. Even the best HELOC rates were below big bank variable rates, which virtually never happens.
  • In late 2011 variable-rate discounts evaporated after S&P downgraded U.S. credit, investors feared the U.S. might default on its debt and Europe fell into a debt crisis. Typical variable-rate discounts crashed from prime – 0.75% or better in the summer to prime – 0.25% or worse by the fall. By year-end 2011, some banks’ posted rates had hit prime plus 0.10%.

betting on ratesBetting on Discounts

We’re frequently asked, “Do you think variable-rate discounts will be similar when I renew in 1, 2,…or 5 years from now?”

It’s an impossible prediction to make. Discounts ultimately depend on random unforeseeable economic events and mortgage market competition.

That said, history has shown that discounts don’t fall much below their current long-term average for long. That average, over the past 20 years, is roughly prime – 0.50%.

In any given year, however, an economic shock can boost inter-bank credit risk and eradicate discounts in a matter of months.

Less dramatic events, like a falling prime rate (which pressures bank profitability) or banks’ desire to rebalance their variable- and fixed-rate mortgage books can also influence discounts—at any time.

If variable discounts ever disappeared once again, the good news is that it would be temporary. Factors that meaningfully shrink variable-rate margins usually alleviate in a few years. Variable discounts then revert above prime – 0.50% once again. In those cases, taking a cheap 1- or 2-year fixed rate is often a wise (and less costly) strategy until floating-rate discounts improve.

 



5 Comments

  • Don’t commissions have a big impact on funding costs?
    If TD pays a 1% commission on a 5yr variable, and if HSBC pays no commission to the bank employee that handles the mortgage application, HSBC could be giving bigger discounts without impacting profitability.

    • The Spy says:

      Hi Ralph, Commissions definitely impact lender costs but they’re usually fixed expenses. Therefore they don’t cause discounts to deviate much at a given lender.

      What you say is true in general, that lenders have more margin to play with when they don’t pay a point to the originator. But all lenders have compensation costs to pay. It’s just a matter of how much and to whom. Fully automated online lenders will someday cut compensation costs to the bone, but we’re not there yet.

  • David says:

    Hey rate spy

    Thanks for that informative post! So I think I’m leaning towards a 1 year fixed rate @ 2.42% over a 5 year variable @2.46%. My thinking is that rate increases are likely over the next year so I’ll save a bit of money and I’ll be able to search for either a similarly good variable discount or another short term fixed at renewal. Thoughts?

  • Will Dunning says:

    There is a related point that bothers me a lot. Consumers sign contracts in which the other party (the lender) can arbitrarily change one of the terms. Yes the discount to prime is specified and can’t be changed during the term. But the lender can change prime and therefore arbitrarily change the actual interest rate. A few years ago we saw two illustrations of this when the lenders only partially followed reductions in the BoC benchmark – it fell by 0.25 both times but primes were reduced by only 0.15. This situation calls out for regulation by the federal government.

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