Since the rate hiking cycle began in March, the Canadian housing market has quickly adjusted to higher interest rates, with mortgage rates having now risen to their highest levels since before the Great Recession. Consequently, despite prices averaging 7%1 less in August than the all-time high reached in February 2022, affordability has deteriorated due to higher rates applied to stress test rules. Mortgage services provider Ratehub.ca recently estimated that “homebuyers would have to earn between $8,660 and $35,760 more in additional annual income to buy a home in June compared to March.” Given this erosion in affordability, it’s no surprise that the Canadian Real Estate Association (CREA) reported that home sales slumped 25% year over year (YoY) in August 2022.
Resales have plummeted on a YoY basis, but in our opinion, they’ve merely reflected a downward normalization, with monthly sales in July averaging somewhat below their 10-year moving average. As such, both the number and share of mortgages in arrears in Canada have continued to decline in 2022 despite higher mortgage rates. The fact that labor market conditions have remained extremely strong has prevented any pickup in mortgage defaults—so far. In our view, if the economy can avoid a sustained and large increase in the unemployment rate, a collapse of the housing market will be avoided.
That said, beyond the large macroeconomic shocks, other pockets of vulnerabilities exist. Trigger rates imbedded in variable mortgage rate contracts recently gathered some attention. The possibility that, once variable rates move beyond the point where more than the totality of variable rate mortgage fixed payments go toward the interest, households face higher monthly payments, is a cause for concern.
The difference between the Canadian housing market and its peers is key
As of 2019, approximately two-thirds of households in Canada were homeowners, a similar proportion to the 68% average for the Organisation for Economic Co-operation and Development (OECD).2 Of those, a slight majority (57%) had a mortgage outstanding, a slightly lower proportion than in the United States (62%) but more than the OECD average (36%). Conversely, 43% of Canadian homeowners (27% of households) owned their home outright (without a mortgage).
But looking under the hood, there’s one main idiosyncrasy that characterizes the Canadian housing market, which is notable for our purposes—Canadian households usually prefer the stability and predictability of fixed interest payments: Over 70% of outstanding Canadian mortgages are structured as a fixed rate mortgage, the majority of which have to be renegotiated every five years.
However, that trend seems to be waning: Since July 2021, the majority of new mortgages have been structured as variable rate. This potentially reflects the earlier rise in fixed interest rates versus variable ones, rendering the former less attractive. This trend has reversed slightly over the last few months, with new mortgages evenly split between fixed and variable rate as of June 2022.
The role of trigger rates
Given that we expect the Bank of Canada (BoC) to continue raising interest rates until at least the end of this year, an increasingly important question is whether the rise in variable mortgage rates will set off trigger rates in the near future. Under such circumstances, some borrowers would have to increase their monthly mortgage payments, potentially causing financial hardship and stress to the Canadian housing market.
Of the 10% of variable rate mortgages outstanding in Canada, 80% have fixed payments, meaning when interest rates move and variable mortgage rates adjust, the total amount paid each month does not change; rather, the proportion of the payment that goes toward interest and principal changes. So when interest rates go up, a larger proportion of the mortgage payment goes toward the interest and a smaller proportion toward the principal. Consequently, the mortgage amortization period gets extended.
Importantly, when interest rates rise enough so that more than the total monthly payment must go toward interest, the mortgage reaches its trigger point; the corresponding interest rate represents the trigger rate. This provision exists so that homeowners always build equity into their home and that the principal owned on the property doesn’t increase. The trigger rate can be approximated by calculating the ratio of the annualized mortgage payment to the outstanding amount for the mortgage.
Since interest rates have mostly trended downward over the past 30 years, trigger rate events constitute a new phenomenon in Canada, so it’s unclear how lenders will treat them, what conditions will be imposed on the buyers, and how these might differ from one lender to another. Likely options include:
- Adjusting monthly payments upward to a reset rate—Theoretically, the reset rate could go from a marginal increase to prevent negative equity payments to a full reset of the market rate in order to preserve the mix of interest and principal paid at mortgage origination. For most lenders, we believe the reset rate will ensure that principal payments continue to a certain extent without necessarily restoring the original mix.
- Making a prepayment (lump sum) on their mortgage in order to reduce the principal—Since the trigger rate is inversely proportional to the outstanding mortgage amount, reducing the mortgage increases the trigger, preventing the breach.
- Switching to a fixed rate mortgage for the remainder of their term—Locking in an interest rate in an elevated rate environment might not be optimal from a personal finance standpoint. Rates have arguably more room to decline than increase over the coming years.
A large proportion of variable mortgages originated in 2021 could reset
Since 2016, the first year of available data, interest rates have generally stayed low, so variable mortgage rates, while having fully adjusted to the 125 basis point (bps) BoC rate hike cycle in 2017/2018, never came close to hitting their theoretical trigger rates embedded into mortgage contracts signed over that period.
In June 2022, the average variable mortgage rate reported by Canadian financial institutions stood at 3.21%, more than twice the 1.50% multidecade low reached in 2021. Since then, the BoC raised its overnight target rate by 175bps across two hikes, and we anticipate variable mortgage rates to fully reflect those three rate hikes over the coming months. So far, our calculations imply that these three hikes will bring variable mortgage rates close, but not significantly above, our estimates for trigger rates.
But here’s the rub: The BoC’s likely not done tightening. We anticipate that the central bank will raise its policy rate to at least 3.75%, its highest level since 2008.3 More importantly, the subsequent adjustment to variable mortgage rates in early 2023 would bring average variable mortgage rates to at least 5.25%, above the average estimated trigger rate from January 2021 to March 2022.
A cause for concern?
From January 2021 to March 2022, Canadian financial institutions underwrote $307 billion in variable rate mortgages; of that, approximately $246 billion had fixed payments (i.e., the payments themselves don’t change with rates, as explained above), or about 36% of total mortgages originated in that time. For an individual house sold for $731,000 (the average home price calculated by the CREA), a 25bps excess of the trigger rate relative to the mortgage rate would translate into an $838 bump up in annual payments, or $64 per month, if the owner decides to increase the monthly payment.4 In all likelihood, that increase would be manageable for most households, albeit with the significant repercussion of greatly extending the amortization period as principal payments remain near zero in that scenario. Should the BoC raise its policy rate to 4.75% (100bps above our base-case assumption), monthly payments would go up by $264 and possibly cause financial hardship to a growing number of households under that scenario. In that severe scenario, it's also important to highlight that trigger rates from before January 2021 could even be breached, increasing the potential pool of mortgages under stress.
Systemic risks remain low, but mortgage renewals will hurt
At first glance, the notional amount of mortgages potentially triggered in early 2023 looks large; however, some mitigating factors exist that we believe reduce the number, duration, and systemic impact of trigger events in the Canadian housing market.
- Since 2018, Canadian borrowers have had to qualify for a higher interest rate than the actual mortgage rate offered by the lender. Revised guidelines by the Office of the Superintendent of Financial Institutions mandate a stress test consisting of the highest rate between either the mortgage rate offered plus two percentage points or the five-year government bond yield. Also, individual circumstances matter, with credit scores, down payments, income, and net worth affecting mortgage rates. Households that contracted a mortgage at a variable rate higher than the calculated average are less likely to see a trigger event based on our interest-rate forecast and calculations.
- As of May 2022, more than 80% of outstanding variable rate mortgages were uninsured. Under Canadian underwriting rules, a down payment of less than 20% requires the homebuyer to contract an insurance policy to protect the lender in case of default.5 In general, households without insurance on their mortgage exhibit a relatively better financial situation, including liquidity and savings, relative to insured mortgages; therefore, under our base-case scenario for interest rates, the risk of widespread default based on trigger rates in early 2023 remains low. Conversely, for insured mortgages, in the event of a default, the insurer compensates the lending financial institution, reducing the potential losses in the system. It’s also worth mentioning that the Government of Canada implicitly supports the Canada Mortgage and Housing Corporation, Canada’s largest home insurer, as it constitutes a crown corporation (i.e., a federal agency).
Finally, while trigger rate risks so far look contained, we believe households will face greater financial hardship at the time of renewal, especially if the level of interest rates needed to cool down the economy stays elevated for longer than we project. If they don’t make prepayments, most households facing trigger events will likely pay very little on their principal for the remainder of their mortgage term; therefore, when renegotiating, lenders will have to reamortize their larger-than-expected principal outstanding over a shorter period of time. That, combined with higher interest payments due to a higher market rate, could potentially lead to broader and larger financial hardship to Canadian households.
All dollar amounts are shown in Canadian dollars.
1 Seasonally adjusted. Unadjusted, homes prices fell 12% in August versus March 2022. 2 OECD. 3 A growing number of analysts forecast the Bank of Canada to raise its policy rate to 4.0% and even above that level. 4 Approximation is based on a 1.62% average variable mortgage rate at origination, a 4.9% trigger rate, a 25-year amortization period with an 80% loan to value, bimonthly payments, and a variable rate reaching 5.1% in December 2022. 5 Other down payment requirements exist; for instance, any home purchased for $1 million or more requires a 20% down payment since home insurance is not available.
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