The Bank of Canada’s (BoC) 7 successive and rapid rate increases totalling 900% this past year have brought many variable-rate mortgages (VRMs) well over and above their fixed payment. Over 9 months, the Key Overnight Rate increased from 0.25% to 4.25% creating unseen problems for many borrowers who started their mortgages at the start of the increasing rate cycle last spring.

As rates increase, VRM holders’ mortgage payments cover less and less of their principal – leaving more of their mortgage balance unpaid.  The housing market is very sensitive to rate increases making property values taper off as expected, thus creating a secondary problem for all mortgage holders in Canada. In this article, we will complete an in-depth review of options available to you if you see yourself in this situation.  How can you mitigate through different financing options when you hit your trigger point, including those offered by default insurers?

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Key Highlights

• More than a fifth of mortgages are affected by trigger rates.
• Amortizations on insured mortgages are limited to 40 years.
• To correct a trigger point, a mortgage must be re-optimized to the original loan-to-value (LTV) ratio 
• Lenders use to provide solutions on a case-by-case basis for each mortgage.
• Borrowers have multiple options to avoid trigger points proactively.

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Triggered Mortgages: Borrowers Hitting their Trigger Rates

There has been an increase in news headlines about borrowers panicking as their variable-rate mortgages (VRM) come close to their trigger rates. Trigger rates occur when a mortgage payment no longer covers any principal repayment, allotting the full payment towards the interest portion. This attribute solely belongs to variable-rate mortgages (VRM) with fixed payments and doesn’t impact adjustable-rate mortgages (ARM) with payments that fluctuate with the prime rate. 

When the interest rates are moving downwards or staying static, this is a non-issue since there are timely payments to the principal component of the VRM payment. However, unlike other times in recent memory, surging interest rates have played into a little-known concern called trigger rates which can leave you with a bigger balance than you originally were loaned. As the Bank of Canada (BoC) increases its overnight rate, 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. 

So far, the Bank of Canada (BoC) has increased rates 7 times last year for a total of 400 basis points (1 basis point is a 100th percentage point), leaving it at 4.25% of the last rate announcement on December 7th.  Mortgage lenders add a spread of 2.20% to  BoC’s Key Overnight to get to their rate, meaning that currently, the prevalent prime rate is 6.45%, but it could rise even further on January 25th.

Triggered Stress: Borrowers Surpassing their Stress-Tested Mortgage Rates

These prime lending institutions make up the vast majority of mortgage originations, according to the Canada Mortgage and Housing Corporation (CMHC), with chartered banks dominating this space. However, a more substantial double-digit percentage is attributed to credit unions and regional lenders, who provide essential services for those not served by mainstream lenders. Each institution should be carefully evaluated depending on the borrower’s needs; prime lenders may naturally offer attractive terms, but it may sometimes not be optimal compared to the value available through an alternate regional lender.

Since the launch of the stress testing requirement for prime mortgages by the Office of the Superintendent for Financial Institutions (OSFI) in October 2016, much debate has ensued among borrowers and mortgage experts. While stress tests are designed to ensure that lenders adhere to OSFI’s lending guidelines, many were quick to remark that stress-testing mortgages with rates of greater than 5.25% or contractual rate plus 2% posed an unnecessary financial burden on potential homeowners. After all, between March 2020 and March 2021, contractual variable rates hover around one-third of the 5.25% stress test benchmark – making this requirement feel pointless to many people within the industry.

In retrospect, it’s clear that the stress test provided legitimate safety and security to Canada’s mortgage and housing market. The Office of the Superintendent of Financial Institutions (OFSI) stress test fostered a slower, steadier, more controlled increase in housing prices by limiting borrowers from over-extending themselves. With the stress test in place, the Canadian housing markets had remained buoyant for some time without inflated bubble-like behaviours, promoting more sound fiscal management for lenders and borrowers alike.

The stress test has proven to be a blessing in disguise by creating a double-edged sword. On the one hand, borrowers were forced to apply more rigorously to qualify for mortgages protecting themselves and lenders in the event of a housing downturn, such as the one we are seeing now.  As an unintended consequence of inflationary pressures and surging property values during the spring lending season of 2022, the more popular and safe fixed rates outpaced variable rates attracting more borrowers to take on added risk with variable rates to qualify for a bigger mortgage.  

At the time, fixed rates were still quite low, so it would have been prudent to qualify for more using variable rates and then convert your mortgage to a fixed rate with an early renewal.  However, with an average difference of 100 bps (1%) at the time,  this was not an option that most borrowers sought until more recently.  Now carrying costs on an ARM are becoming less manageable for many borrowers, and variable rates have started dwarfing the fixed rates.  Also, those in VRMs are concerned about the renewal payment shock when their mortgage comes up, and they need to take stock of the unpaid balances hitting their trigger rate.

Triggered Equity: Borrowers Hitting their Trigger Points

Trigger Points are a real concern for those with a variable-rate mortgage (VRM). It occurs when the mortgage principal balance exceeds the amount initially borrowed due to the increased interest component on their fixed VRM payment. This is caused by an increase in lenders‘ prime rate, as dictated by the Bank of Canada’s overnight rate. As a result, more of their payment is entirely going towards servicing the interest-carry costs. This phenomenon is aptly titled trigger rate and should be avoided by anyone wanting stability and consistent payments for their mortgage.

When the trigger rate is reached, the fixed VRM mortgage payment is completely spent on the interest component; this process is further accelerated as the prime rate keeps increasing. However, as long as the existing equity covers the increasing balance on the mortgage due to the interest component of the mortgage payment, homeowners will have no reason to worry.

Triggered Solutions: Borrowers Reaching Their Trigger Points

As borrowers reach or pass their trigger rates, borrowers’ amortizations will keep increasing alongside the mortgage balance owing. OSFI has limited insured mortgages to 40 years of amortization – while uninsured mortgages may be allowed to exceed this amortization since the risk and onus will be the lender’s and borrower’s sole responsibility.  To limit the risk and exposure to both lenders and borrowers, OSFI has additionally increased the capital requirements for lenders.

Federal mortgage rules require that loans are chronologically amortizing, meaning borrowers must pay down their principal as time elapses. When trigger points have been reached, lenders must reach out to affected clients and offer solutions proactively. Often the best solution is for clients to increase their payment amount to compensate for the higher interest component; however, borrowers can opt for alternative solutions by paying down their principal. In any case, the goal is to bring existing loan-to-value ratios back into line as originally qualified.

When a trigger point is reached, lenders must bring the amortization back to the corresponding chronologically elapsed period – for example, if a client had taken out a 25-year mortgage and it reaches the trigger point after five years, then the mortgage should be reset to 20 years. This rule holds regardless of whether the trigger point is reached due to inaction as a trigger rate was reached or other factors such as an unbalanced loan-to-value due to a reduction in property valuation. 

Fortunately, solutions are available for clients upon reaching the trigger point on their mortgage if they want to end up with an extended amortization period – making it costlier or harder to renew.  It can be costlier to renew to avoid a big payment hike by refinancing and carrying a higher amortization – the additional costs can rack up in legal and appraisal fees.  Additionally, a lower valuation is possible since all properties have devalued due to inflation.  They can opt for early renewal into a fixed rate term, allowing them to keep their amortized period at its current level.

Understanding loan-to-value (LTV) is a key part of financing a home. Its original ratio is determined at the start of the mortgage term and helps borrowers understand what portion of their property is owned by their lender. For instance, if an individual takes out a mortgage with a 20% downpayment on a home worth $1 million, their loan is 80% of the property value, and their LTV would be 80%. However, if the amortized value of this mortgage is over $1 million at 30 years, it will not be insured. If a borrower were to realize a lower value on their property through an appraisal, it would be easier to refinance with at least 20% equity.

Uninsured loans pose a unique challenge regarding default insurance and amortization solutions. As the sole responsibility of the lender, these trigger points must be approached strategically. In instances where the mortgage is originally insured with a loan-to-value (LTV) ratio lower than 80%, the respective insurer would likely have their own set of guidelines regarding how they approach these trigger points, allowing them to mitigate any risk of default.

Default insurers, such as CMHC, Sagen and Canada Guaranty, are providing capitalization options for mortgages that they insured.  Capitalization options allow for negative or reverse amortization rules set by insurers. In the case of CMHC, they are allowing the mortgage balance to grow up to 105% of the original loaned amount.  When a borrower cannot continue making principal and interest payments on a mortgage, it raises the prospect of default. Still, mortgage insurers CMHC and Sagen will allow lenders to do quick loan restructures with individual customers as needed without their approval.

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 continually increase the mortgage payment to cover the interest component, which 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.

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.

Triggered Assets: Borrowers’ Net Worth in Short-Term Jeopardy

Many assets make up an investor’s portfolio, such as jewellery, savings in a bank account, or investments. Other investments, such as those held in RRSPs, TFSAs and pension plans, can be registered. Investments can be non-registered such as your savings or chequing balance, stocks, bonds, or ETFs held outside of registered accounts. But for many Canadians, the single biggest asset in their investment portfolio has been their primary residence – providing untaxed year-over-year in surging growth.

Similar to market-linked investments, properties provide long-term appreciation as they benefit from multiple market cycles by bringing in more participants as their valuations fluctuate. As inflation increases property values while decimating buying power, new generations of Canadians will continue to earn more and participate in the homebuyer’s market. As an existing property owner, you will benefit from this appreciation as equity builds up in your home.

A property’s equity is calculated by determining the difference between what the lender owns (i.e. the mortgage balance) and what a seller would be willing to pay for the property (fair market value). But be sure that there is the only reason to consider the property’s fair market value is if the property is being sold or appraised.  After understanding trigger points, homeowners can confidently plan their next steps by managing their risk appropriately.

At this difficult stage, the homeowner and lender often clash. As the prime rate keeps rising, taxing the property value: not only does the market pressure it downwards, but also increasing interest costs deplete the owner’s equity share. This problematic situation is caused by the added interest being tacked on to mortgages; instead of decreasing along with the paid principal, they increase until they reach their trigger point. Depending on their contract’s loan-to-value (LTV) ratio, trigger points affect more than a fifth of Canadian mortgages – a risk every wary mortgage holder should know before taking on any new debt.

Going back to my original point that, like many other investments, properties are long-term investments which fluctuate over the short term – but appreciate over the long term. Like other inflationary market cycles in the past, properties will not succumb permanently to these pressures and keep increasing in the long term.  This particular inflationary period has been hard, especially for those that purchased their properties at high valuations very recently.

FAQ

Final Thoughts

When looking for a mortgage solution, trigger rates and points should not concern nesto clients. With fixed-rate mortgages and adjustable-rate mortgages available at nesto, trigger rate issues are a non-starter. An ARM stands out as the more attractive option since payments adjust accordingly in real-time with the prime rate; default insurance is an added layer of protection should payment shock occur during the loan’s renewal. Amortization increasing due to trigger rates, therefore, can’t happen as it could with variable-rate mortgages, thus reducing any potential of loan-to-value defaults occurring by making trigger rate solutions unnecessary.

The long-term appreciation of property is expected – even more so in Canada with its lack of housing, increasing need for housing due to immigration, and expectation of an influx of climate refugees in the future as large parts of the world heat up due to global warming.  So, if you think you’ve made a mistake with your purchase, let me remind you otherwise.  Mortgages will be paid down. Amortizations will be reduced as time goes on.  Property values will increase!

You may need to refinance or renew your mortgage to make your payments easier to manage or bring your amortization in line to preserve your equity. You may be sitting on the sidelines for the opportune time to move into homeownership. nesto’s commission-free mortgage experts are ready to assist you in understanding your borrowing options and advise you through these trying times.

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