Variable-rate mortgages with fixed payments: Examining trigger rates

Introduction

For most of 2021 and into early 2022, variable mortgage rates were substantially lower than fixed mortgage rates. As a result, many borrowers opted for a variable-rate mortgage. These types of mortgages now account for about one-third of total outstanding mortgage debt, up from about 20% at the end of 2019.

In Canada, about three-quarters of variable-rate mortgages have fixed payments.1 For these specific mortgages, when interest rates move, the amount of the mortgage payment does not change, but the portion going toward interest (rather than principal) is adjusted. But if interest rates increase substantially, these mortgage borrowers may reach a point where their fixed payments cover only interest and not any principal. The interest rate at which this happens is known as the trigger rate. If rates rise above the trigger rate, borrowers may then need to increase their mortgage payment to cover the additional amount of interest. For some households, this payment increase may be unexpected.

In this note, we examine the concept of trigger rates more closely and discuss what usually happens if a borrower reaches their trigger rate. Of borrowers with a variable-rate, fixed-payment mortgage, we estimate that about 50%—or nearly 13% of all Canadian mortgages—have already reached their trigger rate. This share will rise if banks’ prime rates increase further. However, this calculation does not account for any actions borrowers may take or have already taken to lessen the effects of reaching the trigger rate. As such, our findings represent an upper-bound estimate.

Trigger rates explained

In Canada, major lenders generally offer variable-rate mortgages with either variable or fixed payments:2

• For a variable-rate mortgage with variable payments, the size of regular payments fluctuates as the prime interest rate changes—if prime rates go up, the mortgage payment increases to cover the larger interest component.
• For a variable-rate mortgage with fixed payments, the payment amount is calculated at the beginning of the contract and remains the same for the duration of the loan term.3 Although the total payment amount remains constant, the interest portion of the payment varies with the prime rate, and the residual amount goes to principal. Therefore, if the prime rate rises, the interest portion increases and the principal portion decreases, while the total payment remains fixed.

For variable-rate mortgages with fixed payments, the trigger rate is the interest rate at which the interest portion of the payment equals the total payment amount, and therefore the principal portion is zero.4 If interest rates increase beyond the trigger rate, the amount required to cover the interest payment will be more than the mortgage payment. Each borrower with a variable-rate mortgage with fixed payments is subject to an individualized trigger rate, which is specified in their mortgage contract.5

Interest rates have remained low since the global financial crisis, so few borrowers over the past decade have experienced a situation where the trigger rate has been reached. But with the rapid increases in the policy interest rate by the Bank of Canada since March 2022, variable-rate mortgage borrowers have faced historically large interest rate increases that make reaching their trigger rate a significant possibility. Chart 1 shows how the composition of a fixed mortgage payment evolves for a hypothetical variable-rate mortgage. As the interest rate rises, the portion of the fixed payment going to interest also rises, until it reaches the trigger rate and eventually exceeds the total payment amount.

Chart 1: As interest rates rise, the interest portion of a fixed payment for a variable-rate mortgage grows until the trigger rate is reached

Determining the share of borrowers who have reached their trigger rate

To calculate the share of borrowers who have reached their trigger rate, we use regulatory loan-level data for all mortgages originated or renewed at federally regulated financial institutions. The dataset includes various loan and borrower characteristics, including the:6

• initial (contractual) interest rate
• amortization period
• type of rate—fixed or variable
• size of the loan

We focus on variable-rate mortgages with fixed payments that have not yet reached the end of their loan term as of October 2022.

Chart 2 shows the cumulative share of variable-rate, fixed-payment mortgages that reach their trigger rate at different mortgage rates. At the end of October 2022, typical variable mortgage rates were around 5.1%. We estimate that, at this mortgage rate, about 50% of all variable-rate mortgages with fixed payments had already reached their trigger rate. This represents about 13% of all mortgages.

Chart 2: About half of all variable-rate mortgages with fixed payments reached their trigger rate by October 2022

Moreover, as of the end of October 2022, financial markets anticipate variable mortgage rates will increase by another 50 basis points by mid-2023. In this case, an additional 15% of variable-rate mortgages with fixed payments could reach their trigger rate, with the total thereby reaching 65% (or around 17% of all mortgages).

Certain mortgages will reach their trigger rates sooner. Those that were originated or renewed in 2021, for instance, will tend to reach their trigger rates earlier, mainly because they were issued at extremely low interest rates and often with amortization periods longer than 25 years.

When borrowers reach their trigger rates

Canadian lenders take different approaches for borrowers who reach their trigger rate.

• Some lenders will automatically increase the mortgage payment so that it continues to cover the interest portion of the payment. With this approach, if interest rates rise further in subsequent months, the payment will also need to increase to cover the larger interest payment (similar to a variable-rate mortgage with variable payments).
• Other lenders allow for negative amortization, where the interest payment is permitted to exceed the total mortgage payment. Principal payments are therefore negative, so the balance owed on the mortgage increases from month to month.
• Some lenders contact borrowers before they reach their trigger rate and offer options such as:
  • switching to a fixed-rate mortgage
  • making a lump-sum payment

The Bank of Canada has regular conversations with commercial banks and notes that they are working proactively with their customers who have variable-rate mortgages with fixed payments to determine appropriate solutions on a case-by-case basis.

In the case of automatic payment increases, the magnitude of the change, expressed as a percentage of the original payment, depends on the current interest rate and the trigger rate.

• Of the mortgages that have already reached their trigger rate, we estimate that the median payment increase would have been at most about 5%. This is because the typical mortgage was triggered at a median interest rate of 4.8%, which is only slightly below the rates observed at the end of October 2022 (~5.1%).
• Households that took out mortgages with longer amortization periods when rates were extremely low will have a lower trigger rate and therefore will see a larger increase in payments. For example, continuing with the hypothetical mortgage used in Chart 1, a mortgage originated with a 30-year amortization period and an interest rate of 1.5% would have a corresponding trigger rate of 4.2% (at origination). In this case, we estimate that the monthly payment would have increased by about 20% by the end of October 2022.

The amount by which the required payments need to increase in the future, as well as the share of affected mortgages, will depend on the level at which mortgage rates peak.

Conclusion

Overall, our results suggest that a high share of variable-rate mortgages with fixed payments will have reached their trigger rate by 2023. However, this does not necessarily imply that all of these households will have had to increase their regular payments as a result. Some borrowers may have made prepayments on their mortgage, refinanced their mortgage, switched to a fixed-rate mortgage, or applied other changes since origination that would prevent a payment increase. In addition, households that took out variable-rate, fixed-payment mortgages before the pandemic have likely paid down additional principal relative to their amortization schedule with the decrease in variable rates observed in 2020–21. As a result, our estimates should be interpreted as an upper bound of the impact of trigger rates on households.

That being said, for some borrowers, reaching their trigger rate could result in an unexpected increase in mortgage payments. These borrowers may need to adjust spending or use savings to meet their higher debt obligations. Households that took on a 30-year mortgage during the COVID‑19 pandemic when variable rates were extremely low will generally see a larger increase in mortgage payments. The size of these increases will depend on how short-term interest rates evolve in the future.

Endnotes

References

Bilyk, O., C. MacDonald and B. Peterson. 2018. “Interest Rate and Renewal Risk for Mortgages.” Bank of Canada Staff Analytical Note No. 2018-18.