If interest rates stay higher for longer amid stubborn inflation, experts warn that a growing number of homeowners will be exposed to a trigger rate that would raise their monthly mortgage payments, for some to devastating levels.
“The risk of default from payment resets at the trigger rate should be contained, unless inflation becomes more UN-content,” Rob McLister, mortgage specialist and editor at Mortgage Logic, said in an email to Yahoo Finance Canada.
“No one can say this topic is overblown because we don’t know what’s going to happen next.”
Variable rate mortgages typically have static monthly payments, where less and less of that payment is allocated to principal as rates rise. With interest rates soaring, some homeowners could see their payments reach their trigger rate, which is the point where the portion of interest owed is greater than the payment itself.
Once that happens, the lender could offer the homeowner a number of options, including increasing the overall monthly payment so that it covers at least the entire interest portion, extending the amortization, or requiring a lump sum payment. to reduce the principal loan amount.
While Canada’s biggest banks have said the majority of their mortgage customers could afford an increase in their monthly payments, McLister said some homeowners could find themselves in financial difficulty.
If the Bank of Canada raised its benchmark rate by an additional percentage point, it would “devastate a larger but still modest percentage of household budgets,” he said. He added that a further two percentage point hike would be “catastrophic” and lead to a deeper recession.
The biggest risk, according to McLister, is that the market underestimates inflation and that the Bank of Canada has to move its key rate significantly above 4.25%. Currently, overnight swap data shows that markets expect the overnight rate to reach 4% by the end of the year, up from just 0.25% in March.
“A significant minority of variable rate mortgage debtors would have a negative monthly cash flow given a rise of more than 400 basis points. We could see the government stepping in at that time with some sort of back-up plan. Perhaps regulators would formalize an industry-wide policy allowing for depreciation extensions, for example,” he said.
A progressive problem
“It really depends on where the fares go. And if a person is of the opinion that the rates are going to remain stable at these levels over the next few years, the highest rates are like 2023, 2024, 2025, that would be a greater risk,” Mike Rizvanovic, an analyst of Keefe Bruyette & Woods, said Yahoo Finance Canada in a telephone interview.
Royal Bank of Canada said on its August third-quarter earnings conference call that about 80,000 of its mortgages are expected to reach their trigger rate “with the next two rate hikes.”
“The average raise is about $200. And we only – we have less – materially less than 0.5% of clients who we believe will even need a phone call,” said Neil McLaughlin, group head of personal and commercial banking at RBC, when calling at the time.
During the conference call with Toronto-Dominion Bank analysts in August, the bank said that any variable-rate borrower who strays from their mortgage amortization schedule will need to adjust their payments at renewal to return to the original amortization date.
“One thing that people sometimes get wrong about Canadian banks is that they are a nasty oligopoly where they come to you and kick you out of your house if you miss a mortgage payment. It’s not really that. They will work with you and explore different avenues just so they don’t force you into insolvency because it’s not really in their interest to take over a bunch of houses and try to sell them at potentially struggling,” Rizvanovic said.
But the ability to make monthly payments on time is a major factor in whether banks will work with the borrower.
“They will examine your ability to bear this debt. And it’s really just the people who have maybe a very serious situation where the bank will obviously watch that and recommend, you know, you probably have to sell your house, ”he said.
Shock sticker at renewal
Rizvanovic says rising mortgage rates will become a more pressing issue over time due to the flurry of housing activity during the pandemic, when rates were extremely low.
Using data from Statistics Canada, the Bank of Montreal previously said 60% of new mortgages in December 2021 had a variable rate, indicating their popularity as homebuyers wanted to take advantage of ultra-low rates.
“If you talk about this sticker renewal shock, a lot of that will happen in 2024 and 2025, just given the typical length of time people take on a mortgage, all the elevated activity we’ve seen in the last part of 2020 and for the most part pretty much all of 2021. So they will only see this pain in three, two or three years,” Rizvanovic said.
Banks vs alternative lenders vs private money
Canada’s largest banks control four out of five mortgages, or about 1.6 million mortgages, according to McLister. He estimates that at least 350,000 customers could see their trigger rate activated if the benchmark interest rate reaches 4%, as the market expects.
But banks’ mortgage portfolios have historically shown their resilience in times of economic stress as banks dominate the market for conventional loans.
“Historically, the mortgage portfolio has never really been an issue for direct credit losses. Now that doesn’t mean that in a recession there aren’t credit loss issues and people insolvent, but the losses are usually not directly related to the mortgage portfolio, it’s usually the other things that are unsecured, like credit card debt, car loans,” Rizvanovic said.
He added that the main risk with higher interest rates for longer would be the hit to consumer spending and its impact on the national economy.
Alternative lenders, such as Home Group Inc. or Equitable Bank’s parent company, deal with many unpreferred borrowers, but those lenders are still regulated, which limits risk on their mortgage books, he said. .
For homebuyers who don’t qualify for a loan from regulated lenders, they might turn to the riskier private lending market.
Private lenders consist of small companies or high net worth individuals who lend their own money to fund mortgages and operate outside of regulated financial institutions. Loans are generally short-term, carry a much higher interest rate, and can have high loan-to-value ratios. There is also much less transparency in this market as it is unregulated.
“That’s usually where the bulk of the risk would be. If you think of the Canadian banks, the big six banks, they don’t do subprime mortgages. And I mean, they don’t at all. They are very strict on how they calculate your ability to repay debt,” Rizvanovic said.
Michelle Zadikian is a Senior Reporter at Yahoo Finance Canada. Follow her on Twitter @m_zadikian.
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