The Office of the Superintendent of Financial Institutions (OSFI), Canada’s banking regulator, has issued a cautionary statement highlighting the excessive reliance of both lenders and borrowers on extending mortgage amortization periods.
According to Peter Routledge, the head of OSFI, individuals with mortgages that have insufficient payments to cover the interest portion of the loan could face a significant “shock” in the form of substantially higher payments in the coming years.
In an interview with The Globe and Mail, Routledge emphasized that forthcoming measures to tighten residential mortgage underwriting rules will aim to address the tendency to depend on these types of loans during challenging times. Specifically, some banks offer variable-rate mortgages that allow the loan to negatively amortize, temporarily extending the payment period to help borrowers adjust to higher interest rates. However, the unpaid interest is added to the principal, resulting in larger mortgages and higher monthly payments in the long run.
The concern lies in the fact that many of these mortgage terms are approaching renewal in the next few years. As a result, the extended amortization will revert to the original length, leaving borrowers to face higher payments. Renewals are expected to peak in 2025, during a period when interest rates are predicted to remain high.
Routledge expressed a preference for a lower allocation to variable-rate mortgages.
“If you look at the boom in mortgage lending through 2021 and 2022, we would have preferred a lower allocation to that [variable-rate] product. The system would be a little bit healthier if that product was a little less prevalent,” he said.
However, he clarified that the aim is not to eliminate these options but rather to establish a regulated system that offers more balanced product choices throughout economic cycles.
In January, OSFI unveiled proposals to tighten residential mortgage underwriting rules, known as the B-20 guidelines, for federally regulated banks. These proposals include limiting the proportion of highly leveraged borrowers that a bank can carry on its mortgage book, strengthening debt-servicing metrics, and enhancing stress tests for risky mortgages.
While these rules may make it more challenging for homebuyers to qualify for mortgages, they are intended to address the impact of rising interest rates on loan growth at Canadian banks.
Through its public consultation, which concluded in April, OSFI is considering the proposed measures and additional actions to counterbalance the inclination toward variable-rate mortgages with fixed payments in a low-interest-rate environment. The Financial Consumer Agency of Canada will release guidelines next week on how federally regulated financial institutions can support mortgage borrowers facing severe financial stress, with OSFI contributing to the development of these policies.
Mortgage rates in Canada have doubled in the past year due to increased interest rates set by central banks. Variable-rate mortgage holders have struggled with sudden cost spikes. To mitigate the impact, major banks offer variable-rate mortgages with fixed monthly payments, providing stability as rates rise. However, a larger portion of the payment goes toward covering higher interest expenses while automatically extending the amortization period.
Borrowers eventually reach a trigger rate that necessitates higher payments to continue reducing the mortgage’s size. Nevertheless, certain banks, including Canadian Imperial Bank of Commerce, Toronto-Dominion Bank, and Bank of Montreal, offer products that allow borrowers to surpass the trigger rate while maintaining the same payments, even if they do not cover the full interest owed, up to a specific threshold. The unpaid interest is deferred by adding it to the principal, temporarily increasing the loan size and extending the amortization timeline. When the term ends, banks adjust the payment amount to align with the original amortization period, ensuring the mortgage is paid off on time.
As most outstanding mortgages in Canada are expected to come up for renewal in the next few years, borrowers may experience a 50% increase in their payments when the term ends, especially since interest rates are projected to remain high. While this shock may be manageable given the current low unemployment rate and the mortgage stress test that requires borrowers to prove their ability to sustain higher interest rates, a worsening economic climate could lead to loan defaults triggered by the sudden spike in costs.
Although amortization periods longer than 30 years constitute over one-quarter of the residential loan portfolios at most major Canadian banks, these lenders have indicated that only a small portion of their mortgage books is susceptible to higher credit risks. Routledge attributes this to the strong job market and economy. However, considering Canada’s high household debt levels and rising borrowing costs, OSFI is encouraging banks to remain skeptically aware of prevailing economic conditions, even if it is not predicting an increase in provisions for credit losses.
Currently, there is limited information available on the share of negatively amortizing mortgages in the market. Canadian Imperial Bank of Commerce (CIBC), the only bank disclosing this figure, reported in its second-quarter earnings that negatively amortizing mortgages decreased from $52 billion to $44 billion from the previous quarter. CIBC noted that three-quarters of this reduction resulted from customers voluntarily increasing their fixed payments.
Routledge expressed optimism regarding the banks’ awareness of the risks and their engagement with customers, leading to constructive behavior.
“I’m optimistic that number will go up, but it’s still a serious risk that isn’t going to crystallize in a major way until 2025,” he added.
Information for this story was found via The Globe And Mail and the sources mentioned. The author has no securities or affiliations related to the organizations discussed. Not a recommendation to buy or sell. Always do additional research and consult a professional before purchasing a security. The author holds no licenses.