The Not-so-positive Implications of Negative Amortization Mortgages

Canadians, stodgy and risk averse as we usually are, have long preferred the certainty of a fixed rate mortgage rather than opting for a variable rate that rises and falls with the fortunes of the economy. In fact, 75 per cent of outstanding Canadian mortgages are fixed rate. However, as the Bank of Canada cut its policy rate to near zero to combat the impact of the COVID-19 pandemic, Canadians flooded into variable-rate mortgages. Indeed, about 50 per cent of new mortgages from 2021 to 2022 were variable rate. A common feature of variable rate mortgages in Canada is that rather than a payment that rises or falls with the prime lending rate, about 80 per cent of variable rate mortgages are fixed payment with the share going toward principal falling as rates rise. Normally, this isn’t much of a gamble as interest rates, up until recently, have remained low and steady.

Breaching the trigger

Of course, that all changed in 2022 as inflation began running away from its 2 per cent target, necessitating the fastest Bank of Canada rate tightening in decades. As a result, many variable rate holders found either their amortizations increasing dramatically or worse, that they had breached their contracted “trigger rate”—a situation where a fixed payment, calculated when rates were historically low, was no longer even covering the interest portion of their mortgage. According to the Bank of Canada, over 80 per cent of fixed payment variable rate mortgages originated in 2021 have breached their trigger rate.

There are a few options for borrowers to get back onside of original mortgage contract terms. Lenders may automatically switch the borrower into a fixed-rate mortgage, or they might ask for a lump sum payment or an increase in monthly payments. However, these options may be financially difficult for many borrowers.

Consequently, some lenders are allowing payments to remain constant, thereby blowing out amortizations from a normal 25 years to in some extreme cases more than 50 years. In situations where the payment is no longer covering interest owed, there is what is known as negative amortization, where an unpaid portion of the interest is added to the principal outstanding.

Peak rates – are we there yet?

So what does this mean for current variable rate holders and the wider housing market? Well, not much…for now. However, once a borrower renews their mortgage, they will have to get back onside with a conventional mortgage term and that will mean a potentially much higher payment, with an associated adjustment in household spending and savings. How much higher that payment is, and its eventual impact on the housing market, depends entirely on the trajectory of interest rates over the next five years. If current expectations for the path of the Bank of Canada’s policy rate are accurate, we will begin to see rates lowered late next year, falling from 5 per cent to 2.5 per cent by 2025. Under that scenario, a buyer of a Langley townhouse in 2021 who took out a 1.6 per cent variable would renew in 2026 with roughly an $800 or 44 per cent jump in their monthly payment.

If rates don’t come down much as expected, it could lead to an even larger jump in the monthly payment upon renewal. This presents a risk on the horizon that a substantial portion of buyers may be in a financial position where they need to sell, creating an increase in new listings. One silver lining in this scenario is that there is still a lot of time for households who find themselves in this situation to prepare and budget for higher payments or to make lump sum payments in advance. As for the housing market, it is likely to still be in an undersupplied state three years from now, and so the ultimate impact of higher listings could likely be easily absorbed without causing a major price correction.

The upshot: while the risk stemming from stretched or even negative amortization mortgages is present, there is more than enough time for that risk to be mitigated.

Hypothetical FVREB Borrower