For most of 2020 and 2021, variable rates were much lower than fixed rates. For this reason, many borrowers opted to choose a variable rate mortgage at that time, which now accounts for 20% of all mortgages in Canada. About 75% of these variable rate mortgages have static payments – meaning as the interest rates increase, their mortgage payment, made up of interest and principal components, doesn’t. 

This property of fixed payments on variable-rate mortgages was intended to make it easier for people to budget for them – but we can see that it has the opposite effect in the current market.  Payment shock will be unshelved for many Canadian variable-rate mortgage (VRM) holders’ budgets as they will need to expand upon renewal to account for the principal that was not paid down. Mortgages are intended to pay down a large amount of debt over time (i.e. paying mortgage interest over a specific interval while still paying down some of the principal). 

When interest rates increase substantially, variable-rate mortgage holders can hit a rate at which all mortgage payments go to the interest component – known as the trigger rate.

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Key Takeaways

• More than half of all variable-rate mortgages with static payments in Canada have reached their trigger points.
• nesto offers variable-rate mortgages with fluctuating payments unaffected by trigger rates.
• Being proactive with your situation is advisable for those who have reached your trigger rates.

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How the Bank of Canada is Affecting Interest on VRMs

The Bank of Canada (BoC) has been trying to curb inflation for the last 9 months. One of its key metrics is CPI to measure inflation and increase its Key Overnight Policy rate, one of its most useful tools for controlling monetary policy. The BoC has increased rates 7 times this year for a total of 400 basis points (1 basis point is a 100th of a percentage point, which is 0.01%), leaving it at 4.25%.

As the BoC increases rates, all variable rate mortgage payments increase in tandem as the interest component of their mortgage payment is calculated on the rate discounted from the lender’s prime rate. Most prime lenders in the country use a spread of 2.20% from the BoC’s Key Overnight Rate. This means that the lender’s rate is exactly 2.20% higher than the Bank of Canada’s overnight rate, making the prime rate at most lenders much higher than the current overnight rate of 4.25%.

More Variable-Rate Mortgage Holders Reach their Trigger Rates

As each lender increases their prime rate alongside the Bank of Canada’s overnight rate, the calculated interest on variable mortgages (VRMs) will increase. 

As variable mortgages have a floating rate with a fixed payment, their monthly payment doesn’t increase. However, the portion of the monthly payment that is going towards interest does. This past 50bps rate hike by the Bank of Canada on December 7th means that each $100,000 balance will have a $28 increase in its monthly interest component affecting the payment. 

Trigger rates of any variable mortgage are reached as their payment only goes towards the interest component. As rates climb, more and more variable-rate mortgages are impacted by this increase. 

At the end of October, the Bank of Canada estimated that about 50% of all variable mortgages with fixed payments, or about 13% of all Canadian mortgages, had reached   trigger rates. The point at which the payment is only paying interest – none of it going towards paying down the mortgage principal balance. 

We intend to provide further discussion on this topic, as after another rate hike last week, we believe Big Bank mortgage portfolios have been affected further by trigger rates.

The above chart shows the cumulative share of variable-rate, fixed-payment mortgages that reach their trigger rate at different mortgage rates. At the end of October 2022, typical variable mortgage rates were around 5.1%. We estimate that, at this mortgage rate, about 50% of all variable-rate mortgages with fixed payments have already reached their trigger rate. This represents about 13% of all mortgages. Source: Bank of Canada

What are Trigger Rates and Why are People Worried?

There are two variable-rate mortgages in Canada. Most lenders offer a fluctuating (variable) payment or a static (fixed) payment.  

For variable-rate mortgages with fluctuating payments, the payment will increase to cover any increases in its interest component due to changes in the prime rate. For variable rate mortgages with static payment, the mortgage payment is set at the beginning of the contract’s term and will not change to compensate for any increase or decrease in the prime rate.

In times of deflation, when the economy is cooling down and the Bank of Canada wants to ease monetary policy by decreasing rates, variable-rate mortgages are an exceptional tool to pay your mortgage faster. Your mortgage payment staying the same means more payment goes towards the principal and less interest as the interest component decreases. 

On the contrary, we are currently in a period where we moved from rapid cooling (2020) to an overheated economy (2021-2022) plagued by ever-increasing inflation. This time can be likened to the Bank of Canada (BoC) switching from hitting its car’s accelerator to pumping its brakes in rapid succession to come to a grinding stop. 

The bank’s path to tame inflation hit many bumps along the road in the form of foreign and domestic issues. It is leaving many Canadians to wonder if BoC has not overshot its goal. It’s about trial and error – not every answer works for every problem.

As the variable rate mortgage with the static payment doesn’t increase its payment to compensate for the increase in interest rate – more and more of the mortgage payment ends up going to interest. 

Suppose rates keep increasing, as in the past 9 months of 2022, due to the Bank of Canada’s monetary tightening policies. In that case, the whole payment will eventually be attributed to the interest component. When the whole payment will pay the accrued interest for the payment period and nothing to pay down the principal itself – this point is known as the trigger rate. This effectively means you, as the loan holder, no longer pay down your principal and your time-to-pay-off only increases further. 

The Trickle-Down Effect: How Trigger Rates Impact Bank Portfolios and then Your Mortgage

Trigger rates are personalized and outlined in each variable mortgage contract. As interest rates have remained low since the global financial crisis in 2008, very few variable-rate mortgage borrowers with fixed payments have reached trigger rates.

However, the quick succession of policy rate increases by the Bank of Canada has brought many variable-rate mortgages to their payment inflection point. At this point, when no principal is being paid down, they take a bite out of the retained principal in the property. 

We discussed that the Bank of Canada estimated that 13% of all mortgages were hitting their trigger rates at the end of October; however, since then, we have had 2 more 50bps increases in the policy rate – one at the end of October and another at the beginning of December.

The above chart shows how the composition of a fixed mortgage payment evolves for a hypothetical variable-rate mortgage. As the interest rate rises, the portion of the fixed payment going to interest rises until it reaches the trigger rate and eventually exceeds the total payment amount. Source: Bank of Canada

As the 50bps increase to policy rate was not part of this modelling, researchers expected that 17% of Canada’s total mortgages would be affected by trigger rates at this point as markets were anticipating another 50bps increase, but not til mid-2023. 

However, a total of 100bps will have increased before 2023. Depending on when their payment dates are in relation to the December 7th increase to prime and policy rates – the portion of affected VRMs reaching their trigger rates could have increased significantly.

So, what does this mean for your variable-rate mortgage?

Certain VRMs will reach trigger rates more quickly. Mortgages that were advanced at very low rates between March 2020 after the policy rates were dropped 150bps and before the increases started again at the beginning of March 2022 with amortization periods above 25 years will reach their trigger rates sooner. 

Except for a few big banks in Canada, most offer a fixed payment variable rate mortgage. Big banks being the biggest lenders and holders of these types of instruments, let’s look at each large prime mortgage portfolio individually to see who they are most affected by the Bank of Canada’s rapid monetary tightening. 

How many variable rate mortgages are hitting their trigger rates at RBC, TD, BMO, CIBC, National Bank and Desjardins?

A month before the last prime rate increase in December 2022, RBC, Canada’s largest mortgage lender, reported that 40% of its variable-rate mortgages had reached their trigger rate. At the end of August 2022, after a supersized prime rate increase of 100bps in July 2022, the bank had estimated that 80,000 of its VRM mortgage holders would reach their trigger rates if another couple of rate hikes happened. The 80,000 figure roughly represents 25% of its total 310,000 VRM mortgage holders. 

We can assert that last month’s tipping point for Royal Bank’s variable-rate mortgage (VRM) portfolio leaning on 40% with further elapsing of multiple payment periods alongside another whopping 50bps increase may have moved their notch easily to 50%. 

Additionally, this change is reminiscent of other big lenders as well – the ebbs and flows of the mortgage market systematically drive the business they each add to their books. Overall, VRMs hitting their trigger rates is affecting every big lender similarly concerning their mortgage portfolio – following the split between their fixed and floating rate mortgage portfolios.

Except for Big Red Bank, all other big prime lenders’ variable mortgage portfolios are starting to lean toward hitting their trigger rates. The Big Red Bank is an outlier offering variable-rate mortgages with payments that fluctuate with the prime rate; all other big prime lenders offer variable mortgages with fixed payments.

Why are Nesto clients unaffected by Trigger Rates?

The fluctuating payment on variable mortgages is common to nesto and other mortgage finance companies. Variable mortgages that have payments that fluctuate with the prime rate are aptly known as adjustable-rate mortgages (ARM). The fluctuating payments compensate for the increase in the mortgage payment’s interest component and remain unaffected by trigger rates. 

Trigger rates are the point at which the payment fully goes to the interest component since the monthly payment is not increasing in tandem with prime rates. This is the primary reason that nesto and other mortgage finance companies do not need to worry about their mortgage portfolios risking trigger rates. 

What Happens When You Hit Your Trigger Rate?

Certain variable-rate mortgages are at higher risk of trigger rates. VRMs that originated or renewed in 2021 or have an amortization higher than 25 years are at a higher risk of reaching their trigger rates.

Lenders will provide case-by-case solutions most suitable for the client’s financial situation. Here are possible solutions available to borrowers as they reach their trigger rates.

• Some lenders will automatically increase the mortgage payment to continually cover the interest component – though this may leave the principal from being paid down.
• Other lenders will allow for negative amortization – leaving the balance owing on the mortgage increasing until the borrower hits their trigger point.
• Some lenders will proactively call borrowers before they reach their trigger rate and offer options to switch to a fixed-rate mortgage or make a lump sum payment to reduce their mortgage balance to compensate for the expected increase in interest costs.

What Can You Do When You Hit Your Trigger Rate?

At most times, variable-rate mortgages will provide the most interest cost savings – albeit 2022 is different than the year this is very apparent for most borrowers. You have some options as a variable-rate mortgage holder with static (fixed) payments.

1. If you have the money to pay down your mortgage, you could pre-emptively do this, keeping in mind that Canada’s rates will start heading back down once a recession hits.
2. You could early renew your mortgage to a shorter-term fixed-rate mortgage to ride out the next couple of years of the inflationary period.
3. You could renew to a longer-term fixed rate but only do this if you don’t believe that the Bank of Canada will be able to tame inflation – with or without a recession.
4. If you have the money to pay down your mortgage but don’t want to deal with trigger rates, switch your mortgage to a lender who offers adjustable-rate mortgages – such as nesto. You could pay down your mortgage to make the balance and payment affordable.
5. Refinance your mortgage to increase your amortization while you may also be able to reduce your mortgage payment.

FAQ

Final Thoughts

The Bank of Canada will continue their rate hikes until a starkly marked decline in its inflationary metrics.  In these resolutely unpredictable situations, planning for the worst and hoping for the best is advisable.  It is imperative to understand that housing and shelter are primary needs that will continue to be fueled by our increasing population due to immigration. In contrast, Canada remains a safe and spacious place to call home.  The lack of housing supply, especially while demands continue to grow, will perpetuate inflationary pressures on housing even after the rate hikes have ended.

As rate hikes continue, even more VRMs will hit their trigger rate, and housing prices may continue their slide for a little bit longer.  Prefer your finances, so you don’t miss your chance to move forward with your homeownership goals when the time is right.  For many on the sidelines, this may be the opportunity of a lifetime – don’t get left behind.

While money is easily flowing buying now and paying later mentality works well. As tides reverse in Canada, this strategy can cost more time than money. Increasing mortgage payments as rates increase is a downside with ARMs, but many people would still rather pay now than later. It may be good for your wallet to save money now by having a static payment VRM, but in the long run, you may still be worst off if your mortgage reaches its trigger point. The trigger point is when the amount you owe on your mortgage balance is more than what your home is worth. 

Before making your mortgage changes, contact us to review your options with nesto’s commission-free mortgage experts. We’ll be happy to guide you through this trying time.

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