Bank regulator warns that mortgage holders are leaning too heavily on extending amortization periods

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Canada’s banking regulator is cautioning that lenders and borrowers are overly reliant on lengthening mortgage amortizations to help the latter cope with higher interest rates and surging costs.

In an exclusive interview with The Globe and Mail on Friday, Peter Routledge, the head of the Office of the Superintendent of Financial Institutions (OSFI), said that borrowers with mortgages in which payments are not high enough to cover the interest portion of the loan could experience a “shock” in significantly higher payments in the years ahead.

He added that coming measures to tighten the country’s residential mortgage underwriting rules will aim to curb the tendency to lean on those types of loans in tough times.

Some banks offer variable-rate mortgages that allow the loan to negatively amortize to help borrowers adjust to higher rates by temporarily extending the time frame to pay it off. The unpaid interest is added to the principal, boosting the size of the mortgage and, in the long term, the cost of the monthly payments.

The issue is that many of these terms are coming up for renewal over the next few years, which means that the extended amortization will snap back to the original length, leaving borrowers to soon face higher payments. Renewals are expected to peak in 2025 when rates are likely to still be high.

“If you look at the boom in mortgage lending through 2021 and 2022, we would have preferred lower allocation to that [variable-rate] product. The system would be a little bit healthier if that product was a little less prevalent,” Mr. Routledge said.

“We’re not looking to take those choices away, we just like a regulated system that adds a bit more balance in terms of product choice through a cycle.”

In January, OSFI unveiled proposals to tighten residential mortgage underwriting rules – known as B-20 guidelines – for federally regulated banks. The regulator said it would consider limiting the proportion of highly leveraged borrowers that a bank can carry on its mortgage book, toughening debt-servicing metrics and enhancing the stress test for risky mortgages.

The rules would also make it harder for homebuyers to qualify for a mortgage, squeezing lending at a time when the steep climb in interest rates has dampened loan growth at Canada’s banks.

Mr. Routledge said that through its public consultation, which closed in April, OSFI is considering those proposals and other measures as a way of “counterbalancing that tendency in a low-interest-rate environment for consumers and banks to choose variable-rate mortgages with fixed payments.”

The Financial Consumer Agency of Canada is set to release guidelines next week on how it expects federally regulated financial institutions to support mortgage borrowers that are under severe financial stress. OSFI contributed to the development of the policies.

“That work will be an antidote or at least a partial antidote to some of the individual stresses that could occur in a couple of years,” Mr. Routledge said. “In some ways, that’s probably the most important regulatory initiative to get at this problem.”

Mortgage rates have doubled in the past year. As central banks ratcheted up interest rates, variable-rate mortgage holders have reeled under the pressure of sudden cost spikes.

To soften the blow, most of the big banks offer variable-rate mortgages with fixed monthly payments, meaning that the cost remains steady even as rates rise. The downside is that more of the payment goes toward covering the higher interest expense while the amortization period is automatically extended.

Borrowers eventually reach a trigger rate that requires them to make higher payments to continue reducing the size of the mortgage. But Canadian Imperial Bank of Commerce, Toronto-Dominion Bank and Bank of Montreal offer products that permit borrowers to pass the trigger rate while continuing to make the same payments – even if they don’t cover the full amount of the interest owed, up to a certain threshold.

The portion of interest that is unpaid is deferred by adding it to the principal of the mortgage, increasing the size of the loan and temporarily extending the amortization timeline. When the term ends, banks adjust the amount of the payment to line up with their initial amortization period so that the borrower pays off the mortgage on time.

Since central banks are expected to keep rates higher as the bulk of outstanding mortgages come up for renewal in the next few years, some borrowers could experience a 50-per-cent increase to their payments when the term ends, Mr. Routledge said.

That shock could be manageable since unemployment is low and the mortgage stress test already requires borrowers to prove that they could sustain a higher interest rate. But if economic conditions worsen, then the sharp spike in costs could spur loan defaults.

While amortization periods longer than 30 years make up more than one-quarter of their residential loan portfolios at most of Canada’s largest banks, lenders have signalled that only small portions of their mortgage books have become more vulnerable to higher credit risks. Given the strong job market and economy, Mr. Routledge is not surprised by the low level of mortgages that could turn sour.

The banks have been steadily increasing provisions for credit losses – money that lenders set aside to cover potential loan defaults. Considering Canada’s high household-debt levels and rising borrowing costs, Mr. Routledge said that, while he is not predicting banks will raise provisions, the regulator is encouraging them to be “healthily skeptical of prevailing economic conditions.”

Information on the share of negatively amortizing mortgages in the market is scarce. CIBC – the only bank that discloses that figure – said in its second-quarter earnings report that the amount of negatively amortizing mortgages fell to $44-billion from $52-billion in the previous quarter.

The bank added that three-quarters of that reduction was driven by customers voluntarily increasing their fixed payments.

“Because the banks are aware of the risk and are engaging their customers, and now hopefully customers are aware of the risk themselves, the banks are seeing that constructive behaviour,” Mr. Routledge said. “I’m optimistic that number will go up, but it’s still a serious risk that isn’t going to crystallize in a major way until 2025.”

With reports from Rachelle Younglai