-- How did Canadian banks make billions of dollars in an economic depression?
For the last few quarters, the top Canadian banks made billions of dollars amid a great recession. This is a Canadian pride – we have such a stable banking sector that everyone in the world envies. We have not had a single bank that needed Government’s help. We have been on the road show to garner international praises! This has helped Canadians, the Canadian government in particular.
Truly, we Canadians should be thankful to three things around banks: the management of the banks, ourselves as simple consumers and the government’s banking regulations. I realize that this is a huge topic that requires more extensive research by, perhaps, top researchers from G8 or G20 nations. In this short article, however, I attempt to touch on how Canadian consumers have contributed to the banks’ success through the banks’ use of their powerful business machines – the benefits and costs of publishing posted interest rates.
1. Generally accepted practice: posted interest rates
A simple bank business takes your deposits and lends out the deposited money to consumers who need a loan to satisfy her personal or business needs. You may be a depositor and a borrower at the same time. Banks make their money by giving you a low interest rate when you deposit your money and by charging you a higher rate (than your deposit rate) when you borrow the money. Banks have become the most trusted money intermediary through years of operation, government regulation and insurance requirements. This is a fair business.
In order to make a maximum amount of money, a bank should give you the lowest deposit rates and charge you the highest rates for your loans. This is only possible when banks are in a monopoly situation and they want to maximize their profit. Due to government regulations and market competition, banks never go to the extremes. Plus, they do not want to kill the goose that lays golden eggs! By design, however, they publish higher “Posted Rates” for loans to try to maximize their profits.
When you visit your bank for a consumer loan (either a mortgage or a personal loan), you are generally quoted with their posted rates. If you accept it, it is perfect for the banks. If you do not accept and complain that the rates are high, you will then be offered a lower rate than the posted rate. In most cases, you feel happier to sign on the dotted line when you get further discounts from the posted rates.
2. Posted rates: banks’ psychologically oriented sales weapon
There are numerous studies in consumer psychology and negotiation to show that most consumers fall into this smart trap of sales technique. Banks must have known this for years and have used it to its perfection.
This psychologically manipulative tactic is to ask for the moon and settle for less. The more a seller asks for at first, the more the seller expects to end up with eventually. That’s what happens with the posted rates. When you visit a bank branch for a loan, you will certainly be offered the higher posted rates. If you assumed that your bank was honest enough to list their prices on their products like a supermarket, you would accept their first offer. However, if you showed your displeasure by asking for a discount for a loyal customer, your banker will readily reduce a bit to satisfy you. Now, the bank has retreated once, by reciprocating back, you may accept the second offer right on spot. If you haggle one more time, the banker may retreat one more time for you and you may end us getting a further reduced rate. Many customers would only make just a couple of requests. The loan is then written and you are happily done.
With a slightly lower rate than the posted rate, the bank may have effectively given you a higher rate than an attainable competitive rate on the market. However, psychologically, you are a happy bank customer since the banker compromised a few times and you did the same as well. The naked truth is that inflated interest rates generate higher costs in loans to consumers, but higher profit to the bank!
3. Posted rates: inflated penalty on mortgage termination
Inflated rates suck your money away on daily basis. In the old days, you could experience its outflow through having less coins or notes in your hands. Money was tangible! Today, the spending of money just goes through your account electronically without your notice. How many of us review monthly bank statements? Seeing is believing! Without feeling the money going away physically, we may not notice the high costs of posted rates.
Not only the bank charges you an inflated rate during the term of a mortgage, the largest debt in one’s lifetime for most people, the bank will catch you again when you break your contract. Although you may have already forgotten the “Posted Rate” after the mortgage arrangement, the calculation of the mortgage penalty brings you back to the “Posted Rates” as part of banks’ profiting strategy.
When you break your mortgage contract, you are to pay either three months’ interest or the interest rate differential (IRD), whichever is greater. It is easy to understand and calculate the first part. However, the banks’ IRD calculation is nebulous and must have generated huge profit for the banks due to its use of posted interest rates.
Suppose that you got a discounted rate at 4% for your five year fixed rate mortgage two years ago. The posted rate for the five-year was 6% (but this 6% had no meaning to you during your term if you do not break your contact. As a matter of fact, it is not shown anywhere on your mortgage contract.) To you, without knowing exactly how your bank calculates your IRD, you assumed that they would use the 4% to calculate the interest differential. To your surprise, that’s not the case. The bank will use the 6% as the base rate for calculating your penalty.
Here is the scenario and how the penalty is calculated:
- Number of years remaining: 3
- Contract rate of the mortgage: 4%
- Current 3 year mortgage rate: 3.45% (discounted)
- Outstanding balance: $200,000
IRD = (6%-3.45%) x 200,000 x 3 = $15,300.
3 months’ interest = 4% x200,000/4 = $2,000.
According to banks’ term of contract, you will have to pay an inflated penalty of $15,300. Ironically, if you used the contract rate of 4% to calculate, the IRD is only $3,300! Is this a fair game?
Many of us would be surprised to learn this. Banks’ posted rates not only get you to pay more during the term via their sales tactic, but also haunt you when you break your mortgage. Armed with consumer trusts, banks profit on both ends! It is like “I got you. Twice.”
We all know that many U.S. banks were bailed out by using American taxpayers’ money during this recession. Canadians did not do that through the government. However, Canadians have been bailing banks out continuously through banks’ creative Posted Rates for years!
4. Conclusions
To summarize, I have no conclusion or a call for action here. I believe that smart homeowners will derive their own conclusions as to how to avoid the posted rates and manage their money smartly. Nevertheless, the following questions may be good starters for all of us to answer and reflect:
- A supermarket or even a convenience store can price their products correctly for consumers. How come that the most trusted banks that have the skills and resources cannot price their most profitable products in a way that a consumer can understand its true value?
- When researching on the purposes of banks' posted rates, I was not able to get a handful of previous studies and insights. I may revise this short article should new information is available publicly. Indeed, what is the use of this important "Posted Rates" by the big banks?
- For the largest debt (i.e., a mortgage) you may have had during your lifetime, you started with a non-transparent pricing from the big banks. The interest rate is not negotiated professionally and the contract does not contain full details of the terms (oh, you may find revisable appendix on a bank’s website). Is this something the most reputable businesses (e.g., the banks) in Canada should do?
- If you are the lucky ones who know how to negotiate or worked with a mortgage broker to get your mortgage, you may have avoided the two strikes from the big banks. Well, the “Posted Rates” will try to get you on your mortgage renewal notice again, the third time! What are you going to do with the renewal notices?
[Martin Shao is the President of Valueland Mortgages. He is an established mortgage broker who is not against banks or banks’ honest profits. Forward your mortgage questions to
This e-mail address is being protected from spambots. You need JavaScript enabled to view it
or visit Valueland’s website at http://www.valueland.ca]
