An obscure feature of variable-rate mortgages may push up the monthly payments for an increasing number of borrowers as the Bank of Canada aggressively hikes interest rates.
It’s called the “trigger rate” – the interest rate level that, when surpassed, causes a mortgage holder’s monthly payments to change. The trigger rate has been largely ignored for decades, because the last time Canadians had to deal with fast-rising rates was the late 1970s.
But that is changing. The central bank’s benchmark interest rate is already 125-basis-points higher than in early March. And the rate is expected to march higher until inflation slows.
That means borrowers with a variable rate mortgage whose payment is the same every month pay more interest and less principal with every rate hike. Until the Bank of Canada started raising the benchmark interest rate in March, most of those borrowers saw the same proportion of every monthly payment go toward their principal.
Now that interest rates are rising, these borrowers are moving closer to their trigger rate – a level at which their regular monthly payments will not be enough to cover the interest for the period.
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The exact triggering rate is different for every mortgage holder and depends on the size of their loan, the amount of their monthly payment, the interest rate of the mortgage and length of the amortization period. The impact for a mortgage holder also varies, and the borrower can minimize the risk of unexpectedly breaching the trigger by, for instance, making lump-sum payments on the principal. If they don’t, the lender will lengthen the time it takes to pay off the entire loan until its maximum amortization is reached.
“This trigger rate, once reached, causes the bank to do a check-in with the client to advise adjustments need to be made to the payments to keep it on track,” said Frances Hinojosa, co-founder of mortgage brokerage Tribe Financial Group. “This could be a variation of either a lump-sum payment or adjustments to their mortgage payment.”
A variable-rate mortgage is based on a bank’s prime lending rate, which typically moves with the central bank’s benchmark interest rate.
Eighty per cent of variable-rate mortgage holders in Canada have fixed monthly payments, according to central bank data, where the change to the prime lending rate dictates how much of the monthly payment goes toward principal and how much toward interest. When prime goes up, more of the borrower’s monthly payment will cover the interest and less will go toward the principal. When prime falls, the opposite occurs.
In today’s rising interest-rate environment, less and less is going to principal. Because the monthly payment remains the same, the lender will lengthen the time it takes to repay the loan. When the amortization exceeds the maximum period, or if the monthly payment amount does not cover the interest, then the lender must increase the monthly amount.
Variable-rate mortgages have become much cheaper than fixed-rate mortgages, in which the borrower pays the same interest rate for the term of the loan. The interest rate on the most common term – the five-year fixed mortgage – increased to 4.41 per cent in early June from 2.21 per cent a year earlier, according to Bank of Canada data. Meanwhile, the variable rate mortgage rose to 2.72 per cent from 1.63 per cent over the same period.
That has sent borrowers flocking to variable-rate mortgages. As of April, they accounted for 37 per cent of new insured mortgages, according to the latest data from Statistics Canada and the Bank of Canada. (A borrower needs mortgage insurance if they make a down payment of less than 20 per cent of the purchase price of the home.) That compares to a share of 5 per cent in January, 2020.
It’s a similar trend for uninsured mortgages, where the borrower makes a down payment of at least 20 per cent of the property’s purchase price. Variable rate mortgages made up 56 per cent of April’s new uninsured mortgages compared with 8 per cent in January, 2020.
Every lender will stipulate in the loan documents the interest rate that triggers the higher payment.
“In the recent past, the prime rate has not increased so sharply and within such a short period of time, and few, if any clients have reached the triggering rate,” said Beth Herrema, vice-president of home equity financing at Royal Bank of Canada.
Big Canadian lenders, including Royal Bank and Toronto-Dominion Bank, say they are working on strategies with their borrowers. TD spokesperson Mohammed Nakhooda said the bank ensures that their variable-rate borrowers are “paying down principal no matter where rates go.”
Interest rates and inflation are closely linked, which is why the Bank of Canada has been pushing up its key rate to try and keep inflation to a target of 2%. But it’s a careful balance between controlling inflation and not tipping the economy into a recession. Note - since this video was published in June, inflation has risen to 8.1% in July.
The Globe and Mail
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Rachelle Younglai