Economics 101: Mortgages: fixed, floating or hybrid?
Did you think you had a fixed-rate mortgage only to recently discover it was, in fact, a floating-rate mortgage?
Most major Canadian banks have been selling a hybrid mortgage in recent years which allowed homeowners to pay a fixed payment, however, that payment was based on a floating interest rate which has caused substantial confusion.
National Bank and Scotiabank are the only two major Canadian banks who haven’t sold this type of mortgage. If you’re a client of any of the other banks (RBC, TD, CIBC, BMO), you may have this type of mortgage known as a variable-rate mortgage with fixed payments.
This style of mortgage was popular in a low interest rate environment because homeowners were sold the best of both worlds – fixed payments with the ability to take advantage of lower interest rates.
Unfortunately, a lot of homeowners didn’t comprehend the negative impact on their finances if interest rates increased. In a higher interest rate environment, holders of variable-rate fixed payment mortgages must deal with something called a ‘trigger rate’ – rate at which 100% of their mortgage payment is interest.
Legally, in order to be a mortgage, a portion of each payment must be principal. Therefore, if rates have increased to a level where your payment is 100% interest, you must increase the amount you pay each month or make a lump sum payment to reduce the principal balance of your mortgage. Source: NBF, Bank of Canada
As shown in the chart above, ~70% of variable-rate fixed payment mortgages have now reached their trigger rate. The higher interest rates move, the more mortgages will hit their trigger rate.
The cumulative impact is negative for the economy as Canadian consumers have less discretionary income to spend on other items (clothing, food, travel, etc.). Did the average homeowner fully understand what they were purchasing when their bank or broker sold them a variable-rate, fixed payment mortgage?
Is the average holder of these mortgages able to increase payments when they hit their trigger rate? Will we see a rash of foreclosures as more mortgages hit their trigger rate? I don’t have a crystal ball; however, my sense is that a lot of mortgage holders haven’t planned for higher payments which means more pain for the Canadian economy as the year progresses.
In what most homeowners saw as good news, the Bank of Canada became the first major central bank to pause their fight against inflation by not increasing rates on March 8th.
This contrasts with the US Federal Reserve which has been guiding the market towards higher interest rates. The nightmare scenario for the Bank of Canada (and the economy) is the Federal Reserve increasing rates to 6% which would create an interest rate differential between Canada and the US of 1.5% (6%-4.5%).
An interest rate differential of this magnitude would be very negative for the
Canadian dollar as well as negative for inflation – everything we import becomes more expensive.
The Canadian economy is much more sensitive to interest rates than that of the US primarily because Americans can lock-in mortgage rates for 30-years, whereas most Canadians have locked-in for 5 years or less.
If the Federal Reserve increases rates to 6%, the Bank of Canada will be in a very difficult position – increasing rates further may cause a significant recession while not increasing rates may increase inflation via a weak Canadian dollar.
Eric Van Enk is a wealth adviser & associate portfolio manager with National Bank Financial in Medicine Hat. He is a graduate of the University of Calgary, as well as a CFA charter holder with 20 years of financial markets experience in New York, Toronto and Calgary. He can be reached at eric.vanenk@nbc.ca.