Trigger Rates & Variable Rate Mortgages.
What is a Variable Rate Mortgage?
Trigger Rates & Variable Rate Mortgages are currently a hot topic; let’s dive right into it! A variable rate mortgage is a mortgage which has an interest rate tied to the Bank of Canada’s prime lending rate. With each variable rate mortgage, there is a relationship between the contract rate and the prime rate. For example, if you have a variable rate mortgage at ‘Prime – 1%’, at the time of this article, the Prime rate is currently 6.45%, your effective borrowing rate is 4.95%.
Needless to say, a variable rate mortgage is polar opposite to a fixed rate mortgage. With a fixed rate mortgage, the interest rate and mortgage payment remains constant during the life of the mortgage term. A variable rate mortgage is generally more suitable for a borrower who can budget fluctuating mortgage payments. Some may also prefer a variable rate mortgage given that the pre-payment penalty for a closed mortgage is generally a 3 month interest penalty; whereas with a fixed rate mortgage, the prepayment penalty is the generally the greater of a 3 month interest penalty and the interest rate differential (IRD), which, depending on the interest rate environment and the mortgage loan particulars, could be costlier than a 3 month interest penalty.
What is a Variable Rate Mortgage with Adjustable or Variable Payments?
Traditionally speaking, when one thinks of a variable rate mortgage, they think of an adjustable rate mortgage. When the Prime rate increases, the mortgage payment will increase to capture the increase in interest. Similarly, if the Prime rate decreases, the borrowers mortgage payment will also decrease. Generally speaking, homeowners opt for a variable rate mortgage when they feel that their budget can support a fluctuating mortgage payment. On the contrary, homeowners with a fixed budget or prefer the peace of mind that comes along with a predictable mortgage payment might opt towards a fixed rate mortgage.
What is a Variable Rate Mortgage with fixed payments?
With a fixed-payment variable rate mortgage, also known as a static payment variable rate mortgage, the mortgage payment does not change as it would with an adjustable rate mortgage, instead, remains constant during the term of the loan. However, when the Prime rate increases, a larger portion of the mortgage payment is allocated towards the interest component of the mortgage payment and in turn, less principal is paid down. Given the drastic increases over a relatively short period of time as Canadians have experienced in 2022, many homeowners are being contacted by their bank and alerted that their fixed payment variable rate mortgage payment is nearing, or entirely consisting of interest.
What is a Trigger Rate?
For variable rate mortgages with fixed payments, the trigger rate is the interest rate at which the interest portion of the payment equals the total payment amount, therefore, the principal pay down amount is zero, effectively converting the loan to an interest-only mortgage. In other words, when the Prime rate rises and the fixed mortgage payment is only enough to cover the interest component (no principal), this is known as the trigger rate. This is exactly what we are hearing all over the news and media – homeowners, many of whom has zero idea what a trigger rate is – are being faced with letters or phone calls from their banks advising them that they have, or will soon, reach their trigger rate. This does not come easy for many homeowners who have jumped into the real estate market, some of which already making financial circumstances and have adjusted their lifestyle and spending habits in order to service a mortgage payment and related housing expenses.
What Happens at the Trigger Rate?
Given that the entire mortgage payment is effectively interest-only, principal pay-down is neglected, worse, depending on further interest rate hikes, the regular mortgage payment may not even be larger enough to cover all of the interest, nevermind the principal. Accordingly, mortgage lenders may send notice, or automatically increase the mortgage payment to account for the additional interest. Mortgage lenders may exercise the following steps when their clients fixed payment variable rate mortgage is approaching the trigger rate, or when the mortgage gets ‘triggered’:
- Automatic payment increases.
- May permit negative amortization (without principal reduction).
- Pre-trigger, lenders may offer a fixed-rate option.
- Pre-trigger, lenders may request a lump-sum pay-down.
Why all of a sudden is there talk about Trigger Rates?
For the greater part of 2021 – 2022 variable rate mortgage rates were typically lower than fixed rate mortgages, and more desirable given the additional qualifying power for purchasers who were eager to enter the housing market, and refinance their mortgage to access home equity, given value increases on both sides of the equation. The Bank of Canada estimates that three-quarters of variable rate mortgages have fixed payments. As mentioned above, even when interest rates move, the payment does not change, rather the portion going towards interest does. Given rapid interest rate hikes in 2022, borrowers are realizing that their fixed payment is or may soon only cover interest, and not any principal, this is known as the trigger rate. Accordingly, borrowers are now needing to face payment increases to cover this additional amount of interest which some borrowers did not anticipate, nor have the means to handle.
What Options Do Homeowners Have?
Homeowners with a fixed payment variable rate mortgage may realize that they do not have the financial means to continue making mortgage payments based on increases to the mortgage payments. Alternatively, they may not have the means to make a lump-sum mortgage payment. Some may consider refinancing their mortgage, however, given todays interest rate environment, there may not be much interest rate or mortgage payment relief, especially once factoring in potential pre-payment penalties. This may lead to homeowners seeking alternative financing options, such as second mortgage financing, a short-term option to assist with mortgage payments and living expenses while they evaluate their current situation and determine a long-term course of action.
Trigger rates in the Media.
Our Principal Broker, Daniel Vyner, was recently contacted by Business in Vancouver, to opine on the impacts of trigger rates, and noted that depending on the financial stability of fixed payment variable rate mortgage holders, some may be experiencing financial distress and fear of managing the increased mortgage payments.
Feel free to review a bulletin that was released by the Bank of Canada which can provide additional insights into the reality and ramifications of trigger rates on fixed payment variable rate mortgages.