Variable-rate mortgages are about to trigger payment increases
*Updated Oct. 11, 2022
There has been a lot of discussion recently about how variable-rate mortgage holders could face their “trigger point.” We’re going to explore what that means, and the implications for borrowers.
Let’s first cover the basics. Most variable-rate mortgages have static monthly payments, which protect the borrower’s cash flow from fluctuations in the prime rate. Four of the Big Six banks offer fixed payments for variable-rate mortgages, and so do several credit unions.
But, further Bank of Canada rate increases this fall has led the banks to increase many of these scheduled payments.
This happens when a mortgage’s Trigger Rate and Trigger Point come into play. And it’s most likely to happen first to variable-rate mortgages arranged between the spring of 2020 and early March 2022, when the prime rate was only 2.45%.
The length of the amortization will also play a factor. For those who got a mortgage when prime rate was 2.45% and who have a 30-year amortization, may have already hit their trigger rate following the BoC’s 75-bps rate hike in September. For those with a 25-year amortization, the trigger rate will be reached a little bit later.
There seems little doubt that on October 26, 2022, the Bank of Canada will increase its overnight right again by at least 0.5%, perhaps more.
How can a fixed-payment mortgage increase?
Ron Butler of Butler Mortgage notes that the point of a static payment variable-rate mortgage is that the customer’s monthly payment is not meant to vary when the prime rate changes up or down.
“However, an amortizing mortgage payment has two parts: the interest portion, which changes with prime, and the principal payment portion, which is how the mortgage is paid down,” Butler noted.
“Back in January 2022, a typical Greater Toronto Area (GTA) mortgage of $585,000 had a monthly payment of $2,005 at a rate of, say, 1.45%. This was sliced up as $1,298 towards principal and $707 towards interest,” he added.
“Today, the $2,005 static payment is only contributing $201 towards principal reduction. And when we had another increase of 75 basis points in September, the interest portion exceeded the total $2,005 payment.”
To better visualize the situation, here’s that same example in table format:
When the mortgage starts to grow instead of being gradually paid down, we refer to this as Negative Amortization. In this example, the mortgage has gone from reducing principal monthly by $707 to increasing principal by $144 in just six months! And it is clear from recent statements by Tiff Macklem, there are more rate hikes to come.
Which mortgages will be affected first?
During the month of March 2020, the prime rate dropped three times in quick succession from 3.95% to 2.45%, and variable-rate mortgages arranged while prime was 2.45% have the lowest payments. The lower your interest rate was, the lower your trigger rate, and the faster you may hit this negative amortization.
Frances Hinojosa, CEO of Tribe Financial Group and an Ontario Director on the Mortgage Professionals Canada Board of Directors, says the most common question her mortgage brokerage faces these days is, “when will I hit my trigger rate?”
So much so that she developed a quick and easy formula to help her clients answer this question. It’s not an exact calculation. For this you must ask your mortgage lender, but it is very helpful in telling you roughly when you will hit your trigger rate.
Here you will find a calculator developed from Frances’ formula.
Why do people choose a variable-rate mortgage with a fixed payment?
Mortgage borrowers are often concerned with their monthly payment and how it affects their cash flow, so any mortgage offering the absolute lowest payment is very compelling. Especially if the payment is static.
In fact, very recently variable-rate mortgage borrowers could fix their mortgage payment at a rate at least 2% lower than borrowers who chose a fixed-rate mortgage. (The difference became much smaller after the 100-bps BoC rate hike in July 2022.)
When you look at a real-life example from June 2022, you see the attraction.
A typical GTA/GVA variable-rate static payment mortgage of $585,000 with a 30-year amortization had a monthly payment that was $665 less than its fixed-rate counterpart.
So, if the payment does stay static over the five-year term, the variable-rate client will have spent $39,900 less in total mortgage payments.
And for many borrowers, this lower payment was essential to their mortgage qualification because variable-rate mortgages were stress-tested at a much lower rate.
A recentGlobe and Mailarticle noted, “Nearly three in every 10 homeowners with a mortgage had a variable interest rate at the end of 2021, according to the Bank of Canada. Of those, four out of five had fixed payments.”
However, now that we are in the early days of October, 2022, there are very few people selecting a variable-rate mortgage. They are not too different from the 5-year fixed rates, and with the upcoming BoC increases, we already “know” the variable rate will be higher by year end.
Trigger rates and the trigger point
If the prime rate ever rose to the point where your personal scheduled mortgage payments are only paying interest and not principal, the bank would say you have exceeded your trigger rate.
If you exceed your personal trigger rate, to avoid having your mortgage balance increase, the bank will notify you. They typically recommend that customers increase the mortgage payment or convert to a fixed-rate mortgage to avoid reaching the trigger point (defined below).
When interest rates increase to the point that regular principal and interest payments no longer cover the interest charged, interest is deferred, and the principal balance (total cost) can increase until it hits the trigger point.
The trigger point is when the outstanding principal amount (including any deferred interest) exceeds the original principal amount.
It is hard to be precise because every mortgage is different and each bank has slightly different definitions and approaches to managing the trigger point problem.
When this happens, customers are contacted and generally have three ways they can proceed:
Make a lump-sum payment against the loan amount
Convert with a new loan at a fixed-rate term
Increase their monthly payment amount to pay off their outstanding principal balance within their remaining original amortization period.
Many of these static-payment variable mortgages will hit their trigger rate with the next increase to the prime rate. Keep an eye on things after the next Bank of Canada overnight rate decision on October 26, 2022.
Not many saw this coming. In July 2020, Bank of Canada Governor Tiff Mackem famously said, “We are being unusually clear that interest rates are going to be unusually low for a long time.”
For most of 2021, the Bank of Canada assured markets that interest rate hikes were off the table for at least the next year or longer.
It therefore didn’t seem unreasonable for mortgage borrowers to tap into these extraordinarily low rates and take on a static payment variable-rate mortgage.