If interest rates stay higher for longer amidst stubborn inflation, experts warn an increasing number of homeowners will be at risk of a trigger rate that would hike their monthly mortgage payments, for some to devastating levels.
“Mortgage default risk from trigger-rate payment resets should be contained, unless inflation becomes more un-contained,” Rob McLister, a 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 will happen next.”
Variable rate mortgages typically have static monthly payments, where less and less of that payment goes toward principal as rates rise. With interest rates surging, some homeowners could see their payments reach their trigger rate, which is the point where the interest portion owed is higher than the payment itself.
Once this happens, the lender could offer the homeowner a number of options including hiking the overall monthly payment so it covers at least the full interest portion, extending the amortization, or demanding a lump sum payment to reduce the principal loan amount.
While Canada’s biggest banks have stated the majority of their mortgage customers could withstand an increase in their monthly payments, McLister said some homeowners could find themselves in financial trouble.
If the Bank of Canada hiked its benchmark rate by an additional one percentage point, it “would devastate a larger but still modest percentage of household budgets,” he said. He added that an additional two-percentage-point hike would be “catastrophic” and result in a more severe recession.
The biggest risk, according to McLister, is if the market is underestimating inflation and the Bank of Canada needs to move its key rate materially above 4.25 per cent. Currently, overnight swap data show markets expect the overnight rate to reach four per cent by the end of the year, up from just 0.25 per cent back in March.
“A sizable minority of variable-rate mortgagors would have negative monthly cash flow given a hike over 400 bps. We'd potentially see the government step in at that point with some kind of relief plan. Perhaps regulators would formalize an industry-wide policy allowing for amortization extensions, for example,” he said.
A gradual problem
“It really depends on where rates go. And if a person is of the view that rates are going to be sticky at these levels for the next several years, the higher rates are in the sort of 2023, 2024, 2025 era, that would be a bigger risk,” Mike Rizvanovic, an analyst at Keefe Bruyette & Woods, told Yahoo Finance Canada in a phone interview.
Royal Bank of Canada said in its August third-quarter earnings conference call that about 80,000 of its mortgages were expected to hit their trigger rate “with the next couple of rate hikes.”
“The average increase is about $200. And we only — we have less — materially less than 0.5 per cent of customers that we think will even require a phone call,” Neil McLaughlin, RBC’s group head of personal and commercial banking, said on the call at the time.
In Toronto-Dominion Bank’s August conference call with analysts, the bank said any variable rate borrowers who veer off track with their mortgage loan amortization schedule will have to adjust their payments at the time of renewal so they revert back to the original amortization date.
“One thing that people sometimes get wrong about the Canadian banks is that they're this mean oligopoly where they just come to you and kick you out of your home if you miss a mortgage payment. It's not really like that. They'll work with you and explore different avenues just to not have you forced into insolvency because it's not really in their interest to take possession of a bunch of homes and try to sell them at potentially distressed prices,” Rizvanovic said.
But the ability to make the monthly payments on time is a major factor in whether the banks will work with the borrower.
“They'll look at your ability to carry that debt. And it's really only the individuals that maybe have a very dire situation where the bank will obviously monitor that and recommend, you know, you probably have to sell your home,” he said.
Sticker shock at renewal
Rizvanovic says higher mortgage rates will become a more pressing issue over time because of the flurry of housing activity during the pandemic when rates were ultra low.
Using Statistics Canada data, Bank of Montreal previously said 60 per cent of new mortgages as of Dec. 2021 had a variable rate, a testament to how popular they had become as homebuyers wanted to take advantage of ultra-low rates.
“If you're talking about that sticker shock of renewal, a lot of that will be coming in 2024 and 2025, just given the typical term people take on a mortgage, all the elevated activity we saw in the latter part of 2020 and for the most part, pretty much all of 2021. So they're not going to see that pain until basically three to two to three years from now,” Rizvanovic said.
Banks vs alternative lenders vs private money
Canada’s largest banks control four in five mortgages, or about 1.6 million mortgage loans, according to McLister. He estimates at least 350,000 customers could have their trigger rate activated if the benchmark interest rate reaches four per cent as the market expects.
But the banks’ mortgage books have historically shown their resilience during times of economic stress since the banks dominate the conventional lending market.
“Historically, the mortgage book has never really been an issue on direct credit losses. Now, not to say that in a recession, there aren't problems around credit losses and people going insolvent, but the losses are typically not related directly to the mortgage portfolio. It's typically the other stuff that's unsecured, like credit card debt, auto loans,” Rizvanovic said.
He added the main risk with higher-for-longer interest rates would be the hit to consumer spending and how that impacts the domestic economy.
Alternative lenders, such as Home Group Inc. or the parent company of Equitable Bank, deal with many non-prime borrowers but these lenders are still regulated, curbing the risks in their mortgage books, he said.
For homebuyers who don’t qualify for a loan at regulated lenders, they might turn to the riskier private lending market.
Private lenders consist of small corporations or affluent individuals that lend their own money to fund mortgages and operate outside of regulated financial institutions. The loans are typically short term, carry a much higher interest rate and can have high loan-to-value ratios. There’s also much less transparency into this market since it’s unregulated.
“That's generally where the bulk of the risk would be. If you think about the Canadian banks, the big six banks, they don't do non-prime lending in mortgages. And I mean, they don't do it at all. They're very strict on how they calculate your ability to service the debt,” Rizvanovic said.