What is a trigger rate? This inquiry may seem unfamiliar to many homeowners, but in light of the Bank of Canada’s ongoing interest rate hikes, it’s become an increasingly relevant concern.
Homeowners with fixed-rate mortgages can breathe easy as their payments remain constant, irrespective of interest fluctuations. However, for individuals with variable-rate mortgages, it’s crucial to understand trigger rates, as you may be nearing or already at your trigger rate.
Understanding Trigger Rate
A trigger rate occurs when your standard mortgage payments are insufficient to cover the interest portion. In essence, this leads to the accumulation of negative equity, which is detrimental to both borrowers and lenders alike.
This situation arises within a climbing interest rate context, impacting holders of fixed-payment variable-rate mortgages. With each increase in your lender’s prime rate, a larger portion of your monthly payment goes towards interest rather than the principal. As rates continue to rise, your trigger rate could be reached. Conversely, those with adjustable-rate mortgages (ARMs) are not impacted, as their payments adjust with changes in interest rates.
Calculating Your Trigger Rate
Your mortgage agreement likely includes your trigger rate, so reviewing your contract is a good starting point. However, keep in mind that it may not reflect later developments like prepayments or alterations to your payment schedule; for the latest figure, consult your lender. To calculate your trigger rate, consider the following formula:
(payment amount x number of payments per year / balance owing) x 100 = trigger rate %
For example, a $500,000 mortgage with monthly payments of $2,500 would yield:
($2,500 x 12 / $500,000) x 100 = 6% trigger rate
Reaching your trigger rate can lead to increased mortgage payments, but it serves as a protective measure. Higher interest payments translate to a reduced contribution towards the principal, resulting in extended repayment periods.
Consequences of Reaching Your Trigger Rate
If your payments approach your trigger rate, expect to hear from your lender, who will typically provide various solutions. Addressing the situation proactively is advantageous; a sudden payment increase could strain your finances significantly, so exploring other options is wise.
Option 1: Increase Your Payments
The most common solution is to elevate your payments. Depending on how significantly rates have escalated, the adjustment can be quite substantial. Lenders generally require that your minimum payment not only covers interest but also contributes to the principal. In some cases, extending your amortization period—for instance, from 20 to 25 years—may be necessary to keep payments manageable. Notably, mortgage insurers have advised that insured borrowers (with less than 20% down payment) might extend their amortization up to 40 years.
Option 2: Make a Prepayment
Making a prepayment can raise your trigger rate since it diminishes your outstanding mortgage balance. A lump-sum payment is particularly effective as it directly impacts your principal. Alternatively, adjusting to a more frequent payment schedule, such as advancing to bi-weekly payments, can also help, although it has its limitations. Furthermore, be aware that most mortgages impose restrictions on prepayments; you can usually prepay only a certain amount annually.
Option 3: Switch to a Fixed-Rate Mortgage
Many lenders permit borrowers with variable-rate mortgages to transition to a fixed-rate mortgage without incurring penalties. With fixed-rate mortgages, set payment schedules eliminate the concern of a trigger rate. This option is favored by many, providing a degree of payment certainty, although your monthly commitments may still rise due to current interest rates.
Option 4: Pay Off Your Balance
Eliminating your mortgage means there’s no trigger rate to fret over. However, most individuals lack the funds to pay off their mortgage outright. Even if you had the means, consider prepayment penalties that may apply.
Impact of Rising Interest Rates on Payments
For close to a decade, Canadians enjoyed low interest rates. Homebuyers from 2021 and early 2022 were often advised to opt for variable-rate mortgages for their affordability.
Now, following a series of rate hikes, many borrowers have felt the repercussions. Those with fixed-payment variable-rate mortgages might not have detected immediate changes, while borrowers on adjustable-rate mortgages have seen significant impacts.
For instance, a borrower with a $500,000 mortgage set on a 25-year amortization schedule might have payments as follows:
- 2% interest rate – $2,117.26
- 3% interest rate – $2,366.23
- 4% interest rate – $2,630.10
- 5% interest rate – $2,908.02
- 6% interest rate – $3,199.03
As depicted, transitioning from a 2% to a 4% variable mortgage results in an increment of over $1,000 in monthly payments. Although this might be a painful adjustment, borrowers have had the chance to adapt gradually in response to rate announcements.
In contrast, those on fixed-payment variable-rate mortgages may only face a payment adjustment after hitting their trigger rate. The shock of receiving news that they must increase payments by a substantial amount could understandably cause panic.
Preventing Your Trigger Rate
Now that you’re equipped with knowledge about trigger rates and your options, you can take proactive steps.
As interest rates climb, so does your lender’s prime rate. Many who secured fixed-payment variable-rate mortgages in early 2022 are either nearing or have already reached their trigger rates. Ideally, you should reach out to your lender preemptively to discuss alternatives.
A straightforward strategy is to make prepayments to raise your trigger rate. If making additional payments isn’t feasible, consult your lender or mortgage broker for potential solutions. While extending the amortization period might not be the best choice, it could provide necessary temporary relief.