A perfect storm is starting to brew as homeowners with variable rate mortgages as they are having to increase their mortgage payments to cover the increasing interest rates. To top it off, it may be in a market with decreasing home valuations.
The federal government tried to ease the impact of this with the stress tests owners were required to qualify at when home values were significantly increasing. That has started to correct itself and some Canadian homeowners have started to feel the pinch from a few different directions. Prudent homeowners were careful at the amount of credit they applied for and the price of the home they purchased. Unfortunately, there is a large number of owners who were not so prudent.
Fortunately, lenders also caught on earlier. Some large mortgage lenders are allowing borrowers to shift a portion of their interest costs onto the principal owed on their mortgages, helping them cope with the impact of soaring interest rates.
Variable-rate mortgages are not new but they’re being put to the test in this rising rate environment. With interest rates up 3.5 percentage points so far this year, borrowers are at risk of falling behind on their interest payments and increasing the amount of their original loan.
The variable-rate loans have constant monthly payments and the interest rate on the mortgage is connected to the Bank of Canada’s overnight lending rate. But some of the lenders are allowing the size of the original loan amount, the mortgage principal, to grow in some circumstances. However, some lenders do not allow the principal to increase or are slow to the race.
With every interest rate hike, the cost of borrowing increases and more of the borrower’s monthly mortgage payment is used to cover the interest expenses. When interest rates rise as sharply as they have this year, some borrowers will find themselves in a situation where very little of their monthly mortgage payment is used toward paying down the principal. Borrowers can reach a trigger rate, which often requires them to make higher monthly payments so that they are always reducing the size of their loan, also known as amortization.
Borrowers, with some variable-rate mortgages, may be allowed to go past the trigger rate and stick with payments that don’t even cover the full amount of the interest owed, up to a certain threshold. The unpaid portion of the interest is deferred and added to the mortgage principal and the borrower’s loan balance grows, or negatively amortizes.
Most lenders are saying, in such a scenario, that they pro-actively engage with customers to outline their options and help them choose the one that might best suit their needs.
Increasing bank interest rates
The Bank of Canada’s key interest rate is now 3.75 per cent compared with 0.25 per cent in early March. With the central bank poised to hike interest rates again, more borrowers are about to face a spike in their payments and some may even see the size of their loan grow.
One indicator of stress for the borrower is the length of the amortization period or the time it takes to pay the loan off in full. Over the past few months, a growing share of mortgage loans made by major lenders have amortization periods of more than 30 years.
At a few lenders, the percentage of mortgages with an amortization of more than 30 years recently doubled in a three-month span. Each lender has reported that as of July 31, about a quarter of their residential loan book has mortgages with terms in excess of 30 years.
Federal government regulations
Under federal banking rules, a portion of a borrower’s loan must always be amortizing. But Canada’s bank regulator, the Office of the Superintendent of Financial Institutions (OSFI), has also said that it expects lenders risk management to be responsive to changing conditions, and practices to be adjusted accordingly.
The federal mortgage insurer, Canada Mortgage and Housing Corp. (CMHC), allows the mortgage to grow up to 105 per cent of the variable-rate borrower’s original loan amount. But borrowers whose loan amounts are allowed to increase are at higher risk of finding themselves in a situation where they owe more than their home is worth.
For example, consider a homeowner who made a 5% down payment on a $500,000 property. With deferred interest added back to their mortgage, their loan is allowed to grow to up to $498,750. That is 105% of the original mortgage of $475,000. That’s assuming the borrower hasn’t folded the CMHC insurance premium into their mortgage, which would add another 4% to the loan amount.
At the same time, if that property has faced the typical 10% price drop that has occurred so far this year nationwide, that property is now worth $450,000.
CMHC said the amortization rules for insured mortgages fall under the National Housing Act not under OSFI. It said negative amortizations are allowed if the mortgage payment is recalculated at least once every five years to ensure that the loan can be paid out within the original amortization schedule.
The fact that CMHC rules allow for balances on insured mortgages to grow past the original amount raises questions. Is that prudent? CMHC is a manager of risk on behalf of Canadian taxpayers in the housing market. There is another issue with their policies. Policies that allow mortgage balances to grow. It will cause a likely outsized financial shock for homeowners when their mortgages come up for renewal.
At renewal, lenders must bring the mortgage back in line with the original amortization schedule. For example, consider a borrower who bought a home with a 5 year mortgage amortized over 25 years. After 5 years, their lender will recalculate payments so that the remaining mortgage balance will be paid off in the remaining 20 years.
This will result in higher payments for borrowers who’ve seen their amortization stretch out during the first five years as their mortgage instalments remained the same while their mortgage interest rate rose.
If interest rates at renewal time are higher than the contract rates the borrowers originally signed up for, that will also push up the mortgage payment. And if their loans were allowed to grow during the mortgage term, these borrowers will have a higher mortgage principal to pay down over a shorter period of time. Yes, it will cause financial shock, but it must be anticipated to align with Keeping Life Current.