For many home buyers, choosing between fixed and variable-rate mortgages is one of the most essential steps in the purchase process. A fixed-rate mortgage keeps your interest rate the same throughout your term, which makes your mortgage payment predictable.
This predictability has historically made fixed-rate mortgages popular. But, because of rising prices, variable-rate mortgages became a top choice for many home buyers. In May of 2022, 49% of home loans in Canada were fixed-rate mortgages. That means that 51% of variable-rate mortgages are the majority.
Because of the rise in the popularity of variable-rate mortgages, coupled with the Bank of Canada’s (BOC) interest rates hiking campaign, many variable-rate mortgage holders are seeing a precipitous rise in their mortgage rates. In many cases, an increase doesn’t guarantee a higher mortgage payment. Usually, it means that more of the mortgage payment goes toward the interest costs and less to pay down the loan. Some of these mortgages are close to hitting their trigger rate.
What’s a trigger rate? A trigger rate is the interest rate at which mortgage payments no longer cover the payment’s interest portion. In this case, the mortgage payment will increase.
“Many property owners do not understand the risk of a trigger rate,” says Noreen Durrani, housing advocate. “Because interest rates were low for so long many people have not had to experience this,” Durrani says many people are not informed that this could even happen.
She also says that recent media attention has made people more aware of trigger rates. However, the common consumer might not be as knowledgeable as they should be. So, who may be at risk of hitting their trigger rate? First, we need to understand how a variable-rate mortgage works.
How Does a Variable-Rate Mortgage Work?
If you have a variable-rate mortgage, your mortgage interest rate might increase alongside the BOC rate hikes. If you have adjustable payments, your payment will increase with interest rate hikes. So, you likely don’t have anything to worry about regarding trigger rates.
However, some lenders offer variable-rate mortgages with fixed payments to help security and consistency. With these variable-rate mortgages, your mortgage payment doesn’t increase when interest rates rise. Instead, the proportion of your payment that pays the accrued interest goes up, and the proportion that pays the principal goes down. These variable-rate mortgages are easier to manage because the payments are fixed, but the lower principal payments mean your mortgage will take longer to pay off.
While your mortgage payments will stay fixed through some interest rate increases, interest rates may rise so much that your fixed mortgage payment isn’t enough to pay the interest. This interest rate is the trigger rate. When your mortgage interest rate reaches the trigger rate, your mortgage payment will increase.
Daniel Foch, real estate investor and host of the Canadian Real Estate Investor podcast says that most homeowners understand the risk of trigger rates and that they exist. However, they were unaware or did not understand the consequences of hitting that trigger rate.
What is a Trigger Rate in Mortgage Payments?
We know that variable-rate mortgage holders risk hitting their trigger rate. What does a trigger rate look like? Well, once you reach the point where your entire monthly mortgage payment goes towards interest, none goes to the principal or actual mortgage loan.
Your trigger rate is the interest rate at which your regular payment is no longer enough to pay all the interest you’ve accrued since your last payment. Once you hit this trigger, you aren’t paying down your mortgage any longer because your payment doesn’t cover the interest portion of the loan. In other words, your entire mortgage payment will be interest, and none will go to your principal or actual loan balance.
Your trigger rate depends on your lender and will vary according to several factors. This includes how much equity you have in your home, what kind of mortgage you have, and prevailing market conditions.
You are no longer paying off your mortgage if you reach your trigger rate. Instead, you’re borrowing more money from your lender, and any amount you owe is deferred and added to your balance to be repaid later in the term. In the industry, professionals refer to this as “negative amortization” because even though you’re making payments, the amount you owe continues to climb.
What Happens When You Reach Your Trigger Rate?
Your trigger rate is one of the most important factors when applying for a mortgage. So, when you’re getting ready to apply for a mortgage, make sure you are familiar with this term and know what it means.
If you hit your trigger rate, your lender or mortgage broker will call you to inform you that your payments are not large enough to pay down your mortgage. From there, you’ll receive options for continuing as a borrower. But you can take action before you hit your trigger rate.
How Can You Prepare Before You Hit Your Trigger Rate?
Depending on how comfortable you are taking financial risks, Foch says there are a few options for homeowners at risk of hitting their trigger rate.
First, they can prepare for their monthly expenses to change and adjust their lifestyle accordingly. Second, they can start building up an interest rate reserve — or an emergency fund specifically for rising rates. Third, homeowners could switch to a different mortgage product early for a better rate. And lastly, they could make a lump sum payment. This would reduce the principal balance, gain more equity in their home, and reduce their monthly payments.
“Examine what a worst-case scenario looks like, then prepare for that — financially, emotionally, practically,” says Foch. “This could mean sacrificing other investment positions to put equity into your home or interest payments.”
Ultimately, Foch recommends anyone at risk of hitting their trigger rate should speak to a professional and understand the options.
How to Calculate Your Mortgage Trigger Rate
When attempting to figure out what your trigger rate is, you can calculate yours by using the following formula.
You can calculate the trigger rate (in percentage) by multiplying the payment amount (X) by the number of payments per year, and then by dividing the result by the balance owing, and finally, multiplying by 100.
Let’s say you have a mortgage with a payment amount of $1,000, and you make payments monthly (12 payments per year). If the balance owing on the loan is $5,000, you can calculate the trigger rate as follows:
(Payment amount X # of Payments per year / Balance owing) X 100
With example numbers = ($1000 * 12 / $5000) * 100
Trigger rate = (12000 / 5000) * 100
Trigger rate = 240%
In this example, the trigger rate would be 240%.
What Should You Do if You Hit Your Trigger Rate?
Although it may not feel like you need to change anything because your monthly payment is still the same, don’t ignore the reality that you’re no longer paying your principal balance.
After all, if you aren’t paying enough each month to cover the interest portion of your loan, your mortgage balance is increasing every month. An increasing mortgage balance can lead to higher payments overall or add years to your timeline to become mortgage-free. Each payment that stays the same means that the amount you owe on your home is what increases.
What Are Your Options?
- Increase your monthly mortgage payment
- Make a lump-sum payment
- Extend your amortization period or the length of your mortgage loan
Suppose your lender demands a higher payment. In that case, you are no longer paying off your mortgage, and your debt load will continue to rise as the months pass. Speaking to a professional is critical if you’re in a situation where none of the above choices work for you. They can offer other options, such as refinancing or helping you switch to a fixed-rate mortgage to reduce your principal balance and continue to afford your home.
