Renewal and Refinancing

Risks of Negative Amortization On Your Variable Mortgage

Risks of Negative Amortization On Your Variable Mortgage

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    As a response to rising interest rates, several Canadians are extending their mortgage repayment periods beyond 30 years. But what does this mean? Most are aware of the 2 different types of mortgages: fixed and variable. These are most often assumed as fixed rates having a fixed payment and variable rates having a floating payment, but that is only sometimes true. 

    There are actually 3 types of mortgages: a fixed rate mortgage and 2 types of variable mortgages. One is called variable (VRM), and the other is called adjustable (ARM). The difference is that variable-rate mortgages have fixed payments on a floating rate discounted from the lender’s prime rate. In contrast, the adjustable-rate mortgage has a floating payment based on the discounted rate from the lender’s prime rate.

    When you hear of over-amortization or negative amortization in the news, you’re hearing the impact of rising interest rates, affecting the time it takes to pay off variable mortgages with fixed payments. This post will examine negative amortization and the reality of the 90-year mortgage in Canada that you may have heard about in the news.

    Key Takeaways

    • Variable mortgages can increase the amortization if your payment is static.
    • Many increases to the prime rate may cause you to hit your trigger rate.
    • Trigger rates are hit when all your mortgage payments go toward interest, and trigger points occur when your mortgage balance exceeds your original mortgage amount.

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    What Does It Mean to be Negatively Amortized?

    Amortization refers to the total time it takes to pay off your mortgage through regular payments. The maximum amortization period is typically 25 years for insured mortgages and up to 30 years for uninsured mortgages. 

    Negative amortization occurs when homeowners with variable-rate mortgages (VRM) have a mortgage repayment that grows beyond what they started with. This extension is usually a response to rising interest rates where the mortgage payment no longer sufficiently covers the interest and principal portions. The unpaid amount continues to increase the mortgage balance rather than decrease as it should.  

    When your mortgage ends up negatively amortized, the interest component of your mortgage payment exceeds the fixed payment amount, causing your interest to be deferred and added back to your principal balance. Eventually, the balance will grow, and you will owe more than the original loan amount. 

    This means the homeowner is in debt for a longer period, and the total interest paid over the life of the mortgage increases significantly.

    How Many Canadians Go Beyond a 30-Year Payment Period?

    Recently, Desjardins analyst Royce Mendes estimated that over 20% of the mortgage portfolio of the Big 6 Canadian banks had repayment periods exceeding 30 years in Q1 2023. This figure rose from roughly 2% just a year ago. 

    RBC’s latest Capital Markets report estimates that $260 billion in variable mortgages have amortization periods greater than 35 years, with the bulk of those maturing mid-2025 through 2026.  

    The increasing trend of negative amortization has raised concerns among financial experts and regulators regarding the potential risks associated with such extended repayment periods. 

    Surging Rates: Too Many in Quick Succession

    Recently, we have seen news headlines about borrowers with 70, 80, or 90-year amortizations. These amortizations aren’t offered in Canada, not even on the commercial side, which typically extends up to 40 years. These numbers only exist on paper temporarily, meaning once borrowers with these amortizations come up for renewal, they must bring the amortization back in line with their original amortization schedule. 

    For example, if you started with a 25-year amortization and a 5-year term at renewal, you’ll have to adjust your payments to bring the mortgage back to a 20-year amortization. Although lenders may offer a reprieve by allowing time to adjust back to your original amortization schedule, it’s still in the borrower’s best interest to adjust back as soon as possible to save on interest-carrying costs.

    So, how did these borrowers end up with a 90-year mortgage on paper? 

    Adjustable-rate mortgages (ARM) update the interest rate and payment on the mortgage each time the lender’s prime rate changes. This fluctuating payment reduces the mortgage balance over time, and your mortgage payments will adjust, going up or down accordingly. These types of mortgages will never over-amortize. 

    Conversely, payments on a variable-rate mortgage (VRM) stay fixed while the interest rate fluctuates with the lender’s prime rate. This increases the amortization instead of seeing monthly payments increase to account for adjustments in the interest rate. These types of mortgages are at risk of over-amortizing. 

    When interest rates move downward or remain static, this is a non-issue since there are timely full payments to the principal component of a variable rate mortgage payment. However, in times like today, unlike any other in recent memory, surging interest rates have played into a little-known concern called 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) and doesn’t impact adjustable-rate mortgages (ARM). 

    If you started a variable rate mortgage between April 2020 and March 2022, you may be impacted by trigger rates due to the Bank of Canada rate tightening to curb inflationary pressures. Trigger rates can leave you on the hook with a much larger balance to pay out than what you originally were loaned. 

    VRM and ARM: Same Starting Point, Different Outcomes

    Borrowers who put less than 20% down on their mortgage must purchase high-ratio default insurance from the Canada Mortgage and Housing Corporation (CMHC). This insurance protects the lender if they default on their mortgage. These mortgages are known as insured mortgages. 

    As this insurance reduces the risk for the lender, the lender can offer the borrower a bigger discount on the interest rate. For the two years between March 2020 and March 2022, when the prime rate had dropped to 2.45%, clients were booking insured mortgages at discounts of 1% to 1.20% from the prime rate, effectively carrying rates around 1.40% on average at nesto.

    Let’s look at how a $100K balance is impacted by variable-rate (VRM) and adjustable-rate (ARM) mortgages since interest rates began rising in 2022.

    Date Rate Changed Bank Rate – Lender’s Discount = Client Rate Monthly Payment VRM Monthly Payment ARM Difference (added back to VRM mortgage balance)
    Apr 1, 2020 2.45% – 1.05% = 1.40% $395.25 $395.25 $0
    Mar 2, 2022 2.70% – 1.05% = 1.65% $395.25 $407.92 $12.67
    April 13, 2022 3.20%- 1.05% = 2.15% $395.25 $431.12 $35.87
    June 1, 2022 3.70% – 1.05% = 2.65% $395.25 $455.98 $60.73
    July 13, 2022 4.70% – 1.05% = 3.65% $395.25 $507.97 $112.72
    Sep 7, 2022 5.45% – 1.05% = 4.40% $395.25 $548.92 $153.67
    Oct 26, 2022 5.95% – 1.05% = 4.90%  $395.25 $577.08 $181.83
    Dec 7, 2022 6.45% – 1.05% = 5.40% $395.25 $605.89 $210.64
    Jan 25, 2023 6.70% – 1.05% = 5.65% $395.25 $620.53 $225.28
    June 7, 2023 6.95% – 1.05% = 5.90% $395.25 $635.30 $240.05
    July 12, 2023 7.20% – 1.05% = 6.15% $395.25 $650.20 $254.95

    Comparison between ARM and VRM over the first 5-year term on a $100K mortgage balance over 25-years amortization with a starting rate of Prime less 1.05%. Rate changes and dates correspond with Bank of Canada (BoC) Policy Interest Rate changes. 

    The chart above shows that increasing interest rates did not impact the ARM amortization as the adjusted payments compensated for any changes. Meanwhile, the VRM amortization began to reverse course and climb as soon as interest rates changed. The difference required to cover the change in interest rates will be added to the remaining mortgage balance each month, causing the amortization to increase instead of decrease. 

    What Can We Expect From the Bank of Canada?

    Not many financial experts have been able to predict the BoC’s rate deliberations to any degree of certainty. Everyone makes their best guess, and some end up being correct. Since we can’t say with 100% certainty that the BoC is done increasing interest rates, we will look at the impact on a $100K balance in a few scenarios where interest rates continue to climb.

    The scenarios below will look at changes to amortization, total interest paid and the balance remaining on a possible 25 bps, 50 bps, 75 bps, or 100 bps (1 bps is equal to 0.01%) increase by the Bank of Canada (BoC) before the term ends. We are using nesto’s current best variable 5-year rate of 5.95% as the starting point. More importantly, we will look at the expected change to monthly mortgage payments at renewal

    Why is this important? Well, one of the reasons why someone would get a VRM is to keep their payments static. This is good for clients purchasing their first home to manage their cash flow at the start of their mortgage so they can focus on building savings or paying for furniture to furnish their new home.

    Additionally, many economists believe rates have peaked, allowing borrowers to pay down their mortgage faster if their interest component reduces while their payment stays static.

    In the case where the subject property is a rental, the benefit for the client would be to keep their total interest charged as high as possible to write it off against rental income, leaving a reduced rental income to be taxed. At the same time, it allows them the flexibility to sell their investment property if their goals or financial situation changes while only incurring a 3-month interest penalty.

    Scenario 1 – Bank of Canada increases rates by 25 bps

    Type VRM ARM Difference
    Term Interest $29,738 $29,583 $155
    Remaining Balance $91,263 $90,188 $1,075
    Remaining Amortization 21 years, 6 months 20 years 1 year, 6 months
    Payment at Renewal $664.41 $656.58 $7.83

    Scenario 2 – Bank of Canada increases rates by 50 bps

    Type VRM ARM Difference
    Term Interest $31,152 $30,826 $326
    Remaining Balance $92,677 $90,500 $2,177
    Remaining Amortization 23 years, 4 months 20  years 3 years, 4 months
    Payment at Renewal $688.25 $672.09 $16.16

    Scenario 3 – Bank of Canada increases rates by 75 bps

    Type VRM ARM Difference
    Term Interest $32,585 $32,071 $513
    Remaining Balance $94,110 $90,806 $3,304
    Remaining Amortization 25 years, 8 months 20 years 5 years, 8 months
    Payment at Renewal $712.78 $687.76 $25.02

    Scenario 4 – Bank of Canada increases rates by 100 bps

    Type VRM ARM Difference
    Term Interest $34,036 $33,319 $717
    Remaining Balance $95,561 $91,103 $4,458
    Remaining Amortization 28 years, 9 months 20 years 8 years, 9 months
    Payment at Renewal $738.02 $703.59 $34.43

    It’s important to note that the Office of the Superintendent for Financial Services (OFSI), which regulates all mortgage lenders in Canada, re-iterated that default insurers who insure prime mortgages must maintain capital to allow a maximum amortization of 40 years on these insured mortgages. 

    This change will limit the capitalization in the form of amortization to 40 years when principal payments are not being made to insured mortgages. Currently, we have three default insurers in Canada: Canada Mortgage and Housing Corporation (CMHC), Sagen (GE, also known as Genworth) and Canada Guaranty (CG), which insure all the default-insured mortgages in Canada. 

    What Can You Do If You Find Yourself in This Situation?

    Typically, increases in interest rates don’t surge as quickly as they have over the last 2 years. Usually, any over-amortization of a mortgage will generally even out over the term as rates come down. 

    At renewal, your mortgage will be re-adjusted for any discrepancies, and you may have payment shock. How does that happen? The remaining amortization and larger balance from carrying a static payment will have to be paid down. Your new payment will be based on the remaining mortgage balance on an amortization reduced by your term (ex. 5 years).

    Expect to make higher payments at renewal if rates are rising. Ideally, you may have made prepayments on your mortgage or had an accelerated payment frequency, which will help ease the overall shock upon renewal

    If you are in the middle of your term, you could early renew your mortgage to a fixed rate with your current lender. You would be locked into a higher rate with a much higher payment, but this could help prevent payment shock down the road. Or you could shop around to see if a lender might offer a lower interest rate to renew with them, considering that you’ll have costs to switch or transfer the mortgage and your 3-month interest penalty.

    Once you hit your trigger rate before renewal, your lender will re-adjust your mortgage payment, similar to renewal, to balance your mortgage back to where it should be. The trigger rate occurs when no principal is paid down on your mortgage. To get to that point, only the interest was paid down for a while as rates increased. 

    If you reach a point where your balance owing on your mortgage is more than the original mortgage amount, then you’ve reached your trigger point. Your options are limited once you’ve reached this point. The trigger point occurs when no principal is paid down on your mortgage. To get to that point, you’d have hit your trigger rate, and only the interest was paid down for a while as rates increased.

    When you reach your trigger rate, no action is needed on your end. If you want to avoid hitting your trigger point, you can either increase your payment to compensate or prepay your mortgage balance to bring the amortization back to acceptable levels (usually less than 40 years).

    Your options to put your mortgage back on track can be in various ways, such as:

    •  Principal prepayment to cover the ballooned principal balance. This is only a feasible option for some borrowers if they have significant savings set aside.
    • Increasing your payment to compensate for the additional payment to the principal (we’re likely talking about only a few hundred dollars a month at this point). 
    • Refinance your mortgage to increase your amortization.

    Frequently Asked Questions (FAQs)

    How do I calculate my trigger rate?

    Payment amount x number of payments per year/balance owing x 100 = Trigger rate in %

    So if your payment is $600 biweekly and you owe $360K then your trigger rate will be 4% calculated as 

    $600 per payment x 26 biweekly payments per year / $360,000 balance x 100 = 4%

    What are some of the options available to people who reach their trigger rate?

    • You can renew your mortgage with an adjustment to your payment to bring it in line so you can continue paying down your principal once again.
    • You can pay down your principal and keep your payment the same.
    • You can pay down your mortgage as well as increase your payment – taking advantage of both options to avoid a big surge to your payment or a big hit to your savings.

    What are some of the options available to people who reach their trigger point?

    • Paying down your principal.
    • Increasing your payment.
    • Refinancing your home if you have unrealized gains (trapped equity) in the value of your home since you bought your home.

    Are there 60, 80 or 90-year mortgage amortization periods in Canada?

    The maximum amortization period in Canada is typically up to 30 years for conventional mortgages. However, some homeowners have extended their repayment periods even further due to rising interest rates. It’s important to note that while such extended amortization periods may offer temporary relief in terms of lower monthly payments, they also entail higher overall interest-carrying costs.

    What is the maximum amortization period in Canada?

    For insured mortgages, the maximum amortization period is 25 years. For mortgages where the borrower has a downpayment of at least 20%, the amortization period may extend up to 30 years. Subprime mortgages may allow up to 35 to 40-year amortizations with increased closing costs and mortgage rates. Private mortgages may not consider amortization as a component of their overall lending as they are meant to provide short-term (3 to 6 months) relief to stressed borrowers.

    Final Thoughts

    Like many other Canadians, you may be impacted by inflation and the inability to manage finances easily, much less make a large and unplanned prepayment on your mortgage. That’s when the third option, a refinance, is the most viable option for your situation. 

    Since 2016, refinances have usually been financed at a higher rate as they cannot be default-insured. The risk of default is on the lender, and to compensate for this risk, mortgage refinances typically come with higher rates.

    How can nesto help? We have some of the lowest mortgage rates available, so we can help you save more of your money from interest-carrying costs. And our adjustable-rate mortgage (ARM) won’t leave you at risk of negative amortization at nesto. Reach out and speak to one of our commission-free mortgage experts to see if refinancing is the best option for you.

    Find a better rate, and we’ll match it, beat it, or give you $500*.

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