Number of variable-rate mortgage holders hitting trigger rate will climb to 65 per cent next year, BOC warns

Homes on Sherman Brock Circle in Newmarket, Ont. on Mar 30, 2021.Fred Lum/the Globe and Mail

Canada’s financial system should be able to weather a period of heightened stress, but many recent home buyers could experience a “painful” squeeze as interest rates continue to rise, the Bank of Canada’s second-in-command said Tuesday.

In a speech in Ottawa, senior deputy governor Carolyn Rogers said long-standing vulnerabilities in Canada’s housing market worsened through the COVID-19 pandemic as home prices soared and buyers increasingly relied on variable-rate mortgages, which are linked to the central bank’s benchmark lending missed.

Now that interest rates are rising and home prices are falling, many of these home buyers are experiencing a nasty adjustment, Ms. Rogers said.

The most common variable-rate product has fixed monthly payments. With every interest rate hike, more of the borrower’s monthly payment goes toward interest. However, when the monthly payment no longer covers any principal, the borrower hits what is known as a trigger rate, and their monthly payment rises. In some cases, the lender allows the borrower to shift the interest onto the principal, which increases the size of the mortgage.

Fifty per cent of these variable-rate mortgage holders have already reached their trigger rate, according to estimates from a new Bank of Canada research paper published Tuesday. That share will rise to 65 per cent by the middle of next year as the central bank continues to hike interest rates to rein in inflation.

What is your mortgage trigger rate? This calculator helps you estimate it

“The bottom line is that mortgage costs for some Canadians have already increased, and they will likely increase for others in time, making home ownership more expensive.” Ms. Rogers said.

About 670,000 variable-rate mortgages have been issued since the start of the pandemic, according to the Bank of Canada. Variable-rate mortgages accounted for around 50 per cent of all mortgages issued since mid-2021, compared to an average of 20 per cent in the years before the pandemic.

“This is not a large share of households, but it is larger than it would have been based on historical trends,” Ms. Rogers said.

Borrowers have sought the variable-rate products because borrowing costs have typically been cheaper than fixed-rate mortgages. Part of the motivation was that federal banking rules require borrowers to prove they can make their monthly mortgage payments at an interest rate at least two percentage points higher than their actual mortgage contract.

Homes Bellagio Crescent in Mississauga, Ont.Fred Lum/the Globe and Mail

Problems in the mortgage market can infect the broader financial system if borrowers default on payments. Ms. Rogers said Canada’s banking system is in a good position to handle potential shocks, thanks to reforms following the 2008-09 financial crisis that increased capital and liquidity requirements for lenders and bolstered mortgage stress tests.

Moreover, the central bank is “not expecting a severe economic downturn with the kind of large job losses typical of past recessions,” she said.

But tens of thousands of homeowners will be pinched as interest rates continue to rise. The Bank of Canada is widely expected to raise interest rates again on Dec. 7, either by a quarter-point or half-point. Financial markets expect the bank’s benchmark interest rate to reach 4.25 per cent by early 2023, up from 3.75 per cent today.

The research paper noted that over the past decade, few borrowers had to deal with the trigger rate because interest rates have been relatively low since the global financial crisis.

“But with the rapid increases in the policy interest rate by the Bank of Canada since March, 2022, variable-rate mortgage borrowers have faced historically large interest rate increases that make reaching their trigger rate a significant possibility,” said the paper authored by Stephen Murchison, Advisor to the Governor, and economist Maria teNyenhuis.

Major lenders have downplayed the trigger rate and have repeatedly said only a small subset of their borrowers risk reaching this threshold. The research paper is the first time the central bank has tried to quantify the effects of the higher interest rates on variable-rate mortgage holders.

The researchers estimated that these mortgages account for 13 per cent of all outstanding mortgages. They said this estimate does not account for borrowers proactively making a lump-sum payment or taking other steps to avoid reaching their trigger rate.

Outstanding mortgages include fixed-rate mortgages for which the monthly payment and interest cost remain the same for the term of the loan. It also includes variable-rate mortgages with variable payments for which the monthly amount changes with fluctuations in the central bank’s benchmark interest rate.

The Bank of Canada paper found that variable-rate mortgages now account for about one-third of all outstanding mortgage debt. That compares to one-fifth in 2019.

The central bank is raising interest rates to slow consumer price growth. It does not specifically target home prices, but Ms. Rogers suggested the bank is quite happy to see those prices fall. Nationally, home prices are down by around 10 per cent from the peak in February.

“We need lower house prices to restore balance to Canada’s housing market and make home ownership more affordable for more Canadians,” Ms. Rogers said.

So far, however, rising interest rates have actually made homes less affordable, with rate increases more than offsetting home price declines. Royal Bank of Canada’s national aggregate affordability measure reached its worst-ever level in September.

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