Those in a variable-rate mortgage are taking solace in the fact that their monthly payments haven’t risen, despite a surging prime rate. That’s because variable-rate mortgage payments are generally fixed.
But not always.
In fact, if prime rate were to soar so much that variable-rate borrowers weren’t even covering their interest each month, lenders would typically hike their payments.
The degree of payment risk in this case depends on multiple factors.
How it works ...
Prime rate is at 3.20 per cent. If you’re in a variable-rate mortgage (VRM), it pays to know how much higher prime must go before your payment increases.
At Canada’s largest mortgage lender, Royal Bank of Canada RY-T, for example, the “approximate trigger rate” would be in a range between 5.51 per cent and 5.65 per cent for someone in the first year of a variable, says Arjun Lombardi-Singh, RBC’s senior manager of communications.
That assumes a $500,000 mortgage at prime minus 0.50 per cent (2.70 per cent) with monthly payments and a 25-year amortization. It also assumes prime rate doesn’t drop along the way.
Using this example above, it would likely take another 275-plus basis points of Bank of Canada rate hikes before we saw a trigger rate over 5.51 per cent. As of Wednesday, the market was only pricing in about 225 bps of additional rate increases in the next five years. (There are 100 basis points, or bps, in a percentage point.)
How high can variable payments go?
If trigger rates started getting hit, the jump in variable-rate payments would vary by lender and borrower.
Some lenders hike payments by a fixed amount, or enough to ensure you repay your mortgage within the originally scheduled amortization period. Depending on the mortgage terms, this could potentially boost monthly payments by more than a borrower expects.
At RBC, when a variable-rate payment is increased, “the amount of the increase is the amount required to ensure the accrued interest is paid,” says Mr. Lombardi-Singh. “The payment amount increases by increments of $2.”
That’s a reasonable approach that minimizes payment shock for borrowers.
Tip: If you’re worried that your lender’s trigger rate might boost your payments significantly, ask it to estimate your payment change if, for example, rates were to rise another three percentage points.
Five moves for mortgage holders living too close to their financial edge
What mortgage rate should you choose right now? Three economists weigh in
Even if your payment doesn’t surge during your term, it could when you renew.
Lenders generally reset variable-rate payments at renewal, to ensure your amortization isn’t extended.
In RBC’s case, when the mortgage is renewed “the new mortgage payment will be calculated based upon the originally scheduled amortization period and the client’s rate at time of renewal,” Mr. Lombardi-Singh says.
So, if your first five-year term had a 25-year amortization, your payment would be set at a 20-year amortization when you renewed. That’s common in the industry. And if your payment were to be too high at that point, you could refinance to extend your amortization and get some breathing room, assuming you had 20-per-cent home equity.
Trigger rates aren’t easy to nail down because they vary by borrower, depending on the rate and remaining amortization. The best bet is to ask your lender or mortgage adviser to estimate it, or check your mortgage disclosure statement.
As for adjustable-rate mortgages (ARMs), their payments jump every time prime rate jumps. If rates shoot up as much as the bond market expects, ARM borrowers will eventually be paying up to $90 to $100 more per month, for every $100,000 borrowed, depending on their rate and amortization.
That sort of payment uncertainty is exactly why more people now prefer VRMs to ARMs.
Why variable-rate penalties are cheaper
Ever wonder why prepayment penalties are often so much greater with fixed-rate mortgages?
Standard variable-rate penalties are only three-months’ interest – roughly $800 per $100,000 borrowed, at today’s rates.
But fixed-rate mortgage penalties are usually based on the higher of three months’ interest or the interest rate differential. They can go up to $2,500 to $5,000 per $100,000 borrowed if rates are flat to trending down – depending on your lender and interest rates at the time.
“Fixed-rate mortgages are backed by investors looking for non-fluctuating returns,” says Andrew Gilmour, managing director at CMLS Financial. In other words, the investors and banks who fund fixed mortgages don’t like surprises.
When a borrower breaks their fixed-rate mortgage early, penalties help those investors recoup the return they originally planned on, “which is why the penalty increases as rates on new mortgages go lower,” he says.
“On the other hand, floating rate mortgages are usually quoted as a spread to a floating benchmark, the prime rate for example,” he adds. That spread usually doesn’t change dramatically over the course of mortgage term.
As a result, if you break a variable-rate mortgage early, the investor can usually reinvest at close to the return that was originally planned, “since the same benchmark would be used for a new mortgage,” Mr. Gilmour says.
What’s more, funds for floating-rate mortgages are more often supplied from a bank’s internal sources (deposits, for example), notes Albert Collu, chief executive of Marathon Mortgage Corp. “Those internal cost of funds are not nearly the same as the liability of providing a guaranteed return when securitizing and hedging a fixed-rate mortgage,” he says.
That’s why fixed-rate mortgage penalties can be drastically larger, particularly when rates are falling. And falling rates are indeed likely after our central bank gets inflation under control. At that point, hundreds of thousands of Canadians will be rushing to refinance. And many will be learning about penalties the hard way.
Rates this week
This week was a snoozer for the best five-year rates, which held steady for the most part.
The value zone, if you’re risk tolerant, is in the one-year fixed space. You can still find online mortgage brokers at 2.99 per cent (e.g., Butler Mortgage, True North Mortgage, etc.). They and a few credit unions are pretty much the last bastion of sub-3 per cent mortgage rates in the country.
Rates are as of Wednesday from providers that advertise rates online and lend in at least nine provinces. Insured rates apply to those buying with less than a 20 per cent down payment, or those switching a pre-existing insured mortgage to a new lender. Uninsured rates apply to refinances and purchases over $1-million and may include applicable lender rate premiums. For providers whose rates vary by province, their highest rate is shown.
Robert McLister is an interest rate analyst, mortgage strategist and editor of MortgageLogic.news. You can follow him on Twitter at @RobMcLister.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.
