Got a variable rate mortgage? You could be running the risk of over-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.
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 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.
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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 you do if you find yourself running the risk of over-amortization?
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
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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