With central banks around the globe raising interest rates throughout 2022 to try to wrestle down inflation, some variable rate mortgage holders may see their monthly payments rise.
That’s an expected risk with variable rate mortgages, since the percentage of interest paid on the money owed fluctuates with the prime rate (unlike fixed mortgages, which are set for the duration of the mortgage agreement.)
Mortgage payments have two parts: principal and interest. The principal part of your payment goes toward the actual balance owing on your debt; it’s what brings your actual mortgage down. The interest is the price you pay your bank or other lender for lending you the money to buy a house you wouldn’t be able to buy outright.
There are provisions put in place to make sure you don’t take on more debt than you can afford – and that you can continue to service that debt, if interest rates rise and make those payments bigger. But at a time when the key interest rate in Canada increased by 3% between January and October, bringing the country’s prime rate up to 5.45%, those measures are being put to the test.
“This type of scenario was one of the reasons for the mortgage stress tests that were put in place a couple years ago,” says Jason Heath, a certified financial planner and managing director of Objective Financial Partners Inc.
“Unfortunately, 5% interest rates seemed more theoretical than likely until very recently. But people need to realize it’s a new normal … and people’s budgets need to be adjusted accordingly” – especially if they have a type of mortgage that’s particularly sensitive to rate changes.
It’s important to note that trigger rates don’t apply to fixed-rate mortgages or to variable rate mortgages with adjustable payments. They only apply to variable rate mortgages with fixed payments.
Those are mortgages where, as interest rates rise, a larger portion of your scheduled payments goes toward interest and a smaller chunk pays down the principal. With these types of mortgages, the overall amount you pay doesn’t change, but what part of your debt it services does, which means your monthly budget stays the same but your mortgage debt gets paid off more slowly.
As interests continue to rise, the portion of your payment that services principal grows smaller and smaller. If you reach a point at which your payments are going just to your interest (and therefore not covering any of your principal, or actual mortgage balance), you’ve reached your trigger rate. This is a point where even though you are making regular payments, you are not reducing your debt or building equity.
In essence, you’re triggering more borrowing, because with each payment, you begin owing (and borrowing) more money to pay down interest, and you’re essentially kicking those principal payments you owe down the road.
If rates continue to rise enough, you could even begin owing additional interest on your mortgage because your scheduled payments wouldn’t be sufficient to cover the interest charges from one payment to the next. Your mortgage balance would grow instead of shrink.
How will you know if you’ve reached your trigger rate?
Most major banks will call you or send you a notice as soon as you’ve hit your trigger rate, but like with all things financial, it’s important to be aware of the terms of your agreement so that you can be proactive and make changes if you need to.
“If you’re with a private or a super expensive lender, because your credit rating was not good or your source of revenue wasn’t clear… they might not let you know,” says Elke Rubach, a principal with Toronto-based wealth management firm Rubach Wealth, adding that the terms of your mortgage agreement will be laid out in the fine print of your mortgage documents.
With riskier types of lenders, the owing balance of your mortgage could increase with interest rate hikes for the rest of your mortgage term, but as long as you continue to make regular payments that service the growing interest, the lender will not contact you, until they’re contractually obligated.
The point at which this obligation is set is called the trigger point. This will also be outlined in your mortgage agreement and it isn’t the same for everyone. It’s simply the point where the growing balance of your loan reaches a set percentage of the original amount of your mortgage. That percentage is set by your lender and they will step in to talk about your options and work out a feasible payment schedule only if your balance has grown to this percentage (or you’ve hit the trigger point).
Only variable rate mortgage holders with riskier lenders need to be concerned about trigger points, but it’s something everyone should be aware of.
What can you do if you’re nearing your trigger rate?
“If you’re stuck, talk to your bank, or lender, or reach out to a financial advisor. Look for options, manage your credit, (or think about whether) you need to refinance,” says Rubach.
Whatever you do, she says, “do not do the ostrich approach.”
You may look at increasing the amount of your scheduled payments, make a prepayment and decrease the balance of your loan, or switch to a different payment schedule. You may be able to extend your amortization period if not already at the maximum allowable, switch out of a static/fixed payment schedule, or lock into a fixed rate mortgage.
There are pros and cons associated with each of these options, which you should discuss with your lender or financial advisor, to decide the best option depending on the terms of your mortgage.
According to Heath, even those with fixed or variable rate mortgages with adjustable payments should look at the state of their mortgage well ahead of their renewal period.
“(Given the way interest rates have been trending), it’s very likely that either their mortgage payment will need to increase to stay on the same amortization period, or their amortization period will need to increase to keep their payments at the same level,” he says.
“(Mortgage holders) need to look at what’s happening and consider whether there are things they need to be doing to change their lifestyle and their spending now to be ready (for any changes in the future).”