01/23/2012 03:36 EST | Updated 03/24/2012 05:12 EDT

Before Buying a House, Do the Math

Canadian bond yields have been hovering near historic lows for weeks now, even with equity markets showing a braver face. While investors scratch their heads wondering which market has it right, borrowers are laughing all the way to the bank. Incredibly, the major chartered banks have four-year mortgage rates below three per cent just a week after the Bank of Canada reported that lending standards in this country have actually tightened up a bit.

Indeed, if we look at the spread between term mortgage rates and comparable government bond yields, it has widened since last year. In other words, banks are less willing to pass along the borrowing cost savings to homeowners that they themselves are enjoying in the wholesale market.

While everyone becomes fixated on what the Bank of Canada does with its overnight rate, the real action is in the bond market. The linkage between bonds and mortgages occurs through the term deposit market, or GICs. Since GICs compete with bonds, institutions have to both be competitive in the rates they offer on term deposits, while trying to match their borrowing with the demand for mortgage products. This is why you will often find institutions with significantly different GIC rates for the same term.

Yet, as bond yields head south, and with mortgage demand unchanged, GIC rates trend lower as well and at some point banks pass on the decreases to mortgage rates. Hence, as much as we talk about banks adopting tighter lending standards relative to where bond yields are, the fact of the matter is that mortgage rates have still dropped and have become even more enticing for borrowers.

This is a good news, bad news story though. From an economic perspective, the improved affordability provided by lower mortgage rates suggests a better spring housing market than otherwise expected, especially given that Canada's job market hasn't been the greatest of late. The 45,000 net employment decline in the fourth quarter was the worst performance we've seen since the second quarter of 2009 and the unemployment rate has ticked back up to 7.5 per cent.

Since jobs tend to override rates when it comes to single-unit housing demand, I would caution against getting too excited about prospects for this season. The multiple-unit or condo market is a different kettle of fish. This is an arena where speculative froth has returned and has contributed to the excessive amount of leverage we've seen. Estimates put condo prices at least 10 per cent overvalued in the hottest sectors, like Toronto and Vancouver. New lower mortgage rates will likely add more fuel to the fire, making this a bad development.

With debt to income ratios now well above 1.5 (153 per cent of income was the latest stat and the Bank of Canada announced this week that it expects it to keep climbing), increased leverage is the last thing Canada's economy needs. Whether we deflate housing demand through weaker growth and employment (or incomes) or interest rates head sharply higher, homeowners will be at risk of going underwater.

Let's think back to 1987, when the three-year mortgage rate dipped below 10 per cent (believe it or not, this was considered back to be a very low rate!). When rates headed up to 14.25 per cent by 1990, it sparked a housing recession that lasted years. A comparable move today would land us in the seven per cent region and for high ratio mortgages the impact could be severe.

Now before we start thinking this is some Mayan prophecy, barring additional tightening adjustments to bank lending standards, the only way we'll get a three per cent plus pop in rates is if bond yields do the same. And that means a retracement back to late 2007 levels. While certainly possible, the odds of this happening over a short period of time are remote for a couple of reasons.

First, economic growth prospects here and abroad are not going to be robust over the next few years --at least not enough to prompt a massive correction in bond prices. Second, without a shift in monetary policy, the yield curve will have to steepen significantly and that implies a major realignment of inflation expectations.

Again, it would be naïve to assume this can't happen, but the bookies aren't giving tight odds on it. Still, the advice today for would-be borrowers looking at reaping the benefits from these ultra-low borrowing costs is to first examine the current household balance sheet and make sure there isn't already an excessive amount of debt.

If there is any uncertainty over job prospects, this may not be a great time to take on more debt. If it's a matter of restructuring debt (i.e., collapsing credit card balances and lines of credit into the mortgage), then this might be a great opportunity. Just make sure not to add back to those balanced afterward.