Got a Variable Rate Mortgage? You could be running the risk of over-amortization.
- Variable mortgages can increase your amortization if your payment is static
- Many increases to the prime rate may cause many people to hit their trigger rates
- Trigger rates are hit when all your mortgage payment is going to interest
- Trigger point occurs when your mortgage balance is ballooned to more than your original mortgage amount
- Insured mortgages cannot exceed 40 years of amortization
Most people are aware of 2 different types of mortgages – fixed and variable. These, they would see, as fixed rates having a fixed payment, and variable rates having a floating payment, but that is not always true. There are indeed 3 types of mortgages: a fixed rate mortgage and 2 types of variable mortgages, one is called variable, and the other is called adjustable. The difference is that variable mortgages have fixed payments on a floating rate from the prime. In contrast, the adjustable rate mortgage has a floating payment based on the floating rate from the prime.
Surging Rates: Too Many in Quick Succession
Recently, we have seen news headlines about borrowers panicking as their variable-rate mortgages 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 and doesn’t impact adjustable-rate mortgages.
Adjustable rate mortgages update the rate and payment on the mortgage each time the prime rate fluctuates. This fluctuating payment reduces the mortgage balance over time. Conversely, payments on the variable mortgage stay fixed, while the interest rate fluctuates in tandem with the prime rate. This increases the amortization instead of having the inverse effect.
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 variable rate mortgage payment. However, in times like today, which is unlike any other in recent memory, surging interest rates have played into a little-known concern called trigger rates. If you started a variable rate mortgage anytime between April 2020 and March 2022 then you may be impacted by trigger rates. Trigger rates can leave you on the hook with a bigger 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.
Let’s look at how a $100K balance is impacted by variable rate (VRM) and adjustable rate (ARM) mortgages over their life.
|Date Rate Changed||Bank Rate – Lender’s Discount = Client Rate||Monthly Payment VRM||Monthly Payment ARM|
|Apr 1, 2020||2.45% – 1.05% = 1.40||$395.25||$395.25|
|Mar 2, 2022||2.70% – 1.05% = 1.65||$395.25||$406.80|
|April 13, 2022||3.20%- 1.05% = 2.15%||$395.25||$430.43|
|June 1, 2022||3.70% – 1.05% = 2.65%||$395.25||$454.71|
|July 13, 2022||4.70% – 1.05% = 3.65%||$395.25||$505.46|
|Sep 7, 2022||5.45% – 1.05% = 4.40%||$395.25||$536.79|
|Oct 26, 2022||5.95% – 1.05% = 4.90%||$395.25||$562.43|
|Dec 7, 2022||6.45% – 1.05% = 5.40%||$395.25||$588.63|
As it is evident from the chart above, the adjusted payment client’s amortization was not impacted by increasing interest rates – their adjusted payment compensated for any changes saving them 28yrs in the total time it takes to pay off the mortgage – as well as saving them more than $8K in total interest paid/charged on the life of their mortgage.
The chart above can be used for any balance on your mortgage – using it as a factor of $100K; however, the dates and changes to the prime rate must match with your own mortgage’s history for the values to be meaningful for your own mortgage situation.
Assuming that the start date of your mortgage and interest rate are the same, then factor by any value. For example, if your starting balance is $400K then you would multiply the initial payment, the remaining balance, and the total interest paid by a factor of 4. However, the remaining amortization would not be factored in and would stay the same.
What can we expect from the Bank of Canada?
There are not many financial experts that 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. For this reason, we will look at the impact of the same $100K balance on a few different scenarios that could come true this Wednesday, October 26th.
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). But more importantly, they will look at the expected change to the monthly mortgage payment for both clients 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 save 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. In the case where the subject property is a rental then the benefit for the client would be to keep their total interest charged as high as possible to be able to write it off against rental income – leaving a reduced rental income to be taxed.
Scenario 1 – Bank of Canada increases rates by 25 bps
|Remaining Amortization||61 yrs, 11 m||20 yrs, 0 m||41 yrs, 11 m|
|Payment at Renewal||$616.60||$558.83||$57.77|
In the scenario above, the client saved more than 41 years and over $9K in principal payments over the 5-year term by going with a fluctuating payment on an ARM versus a static payment on a VRM.
Scenario 2 – Bank of Canada increases rates by 50 bps
|Remaining Amortization||123 yrs, 10 m||20 yrs, 0 m||103 yrs, 10 m|
|Payment at Renewal||$636.42||$572.57||$63.85|
In this scenario, the client saved more than 141 years and over $9K in principal payments over the 5-year term by going with a fluctuating payment on an ARM versus a static payment on a VRM. The client will save more than 103 years in amortization by going with an ARM. At some point between an increase of 25 bps and 50 bps, the client hits an amortization of 161 years.
Scenario 3 – Bank of Canada increases rates by 75 bps
|Remaining Amortization||UNKNOWN||20 yrs, 0 m||141 yrs, 4 m|
|Payment at Renewal||$656.73||$586.47||$70.26|
In this scenario, the client saved more than 141 years and over $10K in principal payments over the 5-year term by going with a fluctuating payment on an ARM versus a static payment on a VRM. At some point between 25 bps and 50 bps, it is not conclusive exactly how many years the client saves as our amortization tool caps out at 161 years.
Scenario 4 – Bank of Canada increases rates by 100 bps
|Remaining Balance||$99, 310||$88,025||$11,285|
|Remaining Amortization||UNKNOWN||20 yrs, 0 m||141 yrs, 4 m|
|Payment at Renewal||$677.55||$600.55||$76.99|
In this scenario, the client saved more than 141 years, and over $11K in principal payments over the 5-year term by going with a fluctuating payment on an ARM versus a static payment on a VRM. At some point between 25 bps and 50 bps, it is not conclusive exactly how many years the client saves as our amortization tool caps out at 161 years.
It is also important to note that the Office of the Superintendent for Financial Services (OFSI), which regulates all mortgage lenders in Canada, re-iterated on September 28th that default insurers who insure prime mortgages must maintain capital to allow for maximum amortization of 40 years on these insured mortgages.
This change will limit the capitalization in the form of amortization when principal payments are not being made to insured mortgages at one of the default insurers to a maximum of 40 years. Currently, we have three default insurers in Canada, Canada Mortgage and Housing Corporation (CMHC), Sagen (GE also known as Genworth) and Canada Guaranty (CG). This means that you won’t be able to surpass more than 40 years so you would never reach an amortization of 161 years as shown in our scenarios above.
What can you do if you find yourself in this situation?
Typically, increases in interest rates don’t surge as fast. Usually, any over-amortization of a mortgage will generally even out over the course of the term as rates come down. However, there is no certainty in life and this time around everything is quite atypical with our financial markets as they are having their own set of concerns and divergent priorities.
Regardless of the road you take, at renewal time your mortgage will be re-adjusted for any discrepancies and you may have a payment shock. How will 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 that is reduced by your term (in this case, 5 years).
Expect to pay higher payments 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 locking into a higher rate with a much higher payment. Or you could shop around to see if there is a lender who might offer a lower interest rate to renew with them – taking into account that you’ll have costs to transfer the mortgage and also your 3 months’ worth of interest penalty.
Once you hit your trigger rate prior to 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 there is no principal being paid down on your mortgage – to get to that point only the interest has been paid down for a while as rates were increasing. At this 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 40yrs).
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 and there are a limited number of options left. The trigger rate occurs when there is no principal being paid down on your mortgage – to get to that point only the interest has been paid down for a while as rates were increasing.
At this point, you will be required to put your mortgage back on track. This can come in multiple ways, such as
- Principal prepayment to cover the ballooned principal balance – this is not a feasible option for all borrowers unless they have some large savings set aside, or
- Increasing your payment to compensate for the additional payment to the principal (we’re likely talking about only a few hundred dollars at this point), or
- 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.
Final Thoughts: What Can nesto Do For You?
You may be like most Canadians going through inflation and not being able to manage finances easily – much less make a massive and unplanned prepayment on your mortgage. That’s when the third option is most viable for your situation – refinance.
Refinances are usually done at a higher rate as they cannot be default insured since 2016. The risk of default is the onus of the lender as such they are priced at higher rates.
How can nesto help? Well, we have some of the lowest mortgage rates available so we can definitely help you save more of your money from interest-carrying costs. Reach out and speak to one of our commission-free mortgage experts to see if refinancing is the best option for you.
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