In the realm of Canadian mortgages, a concerning trend emerged in 2022 known as negative amortization. This occurs when the monthly mortgage payments fail to cover both the interest and principal portions of the loan, resulting in an increasing loan balance instead of a decrease. This article delves into the intricacies of negative amortization, its prevalence in variable-rate mortgages with static payments, and its impact on homeowners. Moreover, it discusses recent regulatory responses and proposes effective methods to address and mitigate the risks associated with this issue.

Negative Amortization: An Overview

Negative amortization, often associated with variable-rate mortgages and interest-only payment plans, manifests when the interest component of a mortgage payment exceeds the fixed payment amount. This results in unpaid interest being added to the principal balance, leading to a growing loan balance instead of its reduction over time. The scenario is exacerbated by rising interest rates, particularly concerning for homeowners with variable-rate fixed-payment mortgages.

Causes of Negative Amortization

Two primary factors contribute to negative amortization:

1. Variable-Rate Mortgages (VRMs): With VRMs, the interest rate fluctuates based on market conditions. If the interest rate rises significantly, the static mortgage payment may no longer be sufficient to cover the increased interest, leading to unpaid interest being added to the principal.
2. Interest-Only Payment Plans: Interest-only payment plans allow borrowers to pay only the interest for a specific period. As no principal payments are made, the loan balance remains unchanged. Once this interest-only period ends, the borrower must begin making principal payments, potentially resulting in a higher monthly payment.

Regulatory Response to Negative Amortization

Canada’s federal banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), has recognized the risks associated with negative amortization. In response, OSFI is preparing to implement changes that will require banks to hold more capital against mortgages where payments fail to cover even the interest, and the loan balance is greater than 65% of the property value. These changes aim to mitigate the risks for banks and mortgage insurers posed by negative amortization.

Fixed Payment Variable Mortgages Have Also Helped

Fixed-payment variable-rate mortgages work by keeping the borrower’s monthly payments steady even as interest rates increase. While a larger portion of the payment goes towards interest costs, the amount allocated to principal repayment decreases, effectively stabilizing the monthly payment for the borrower. This structure has proven invaluable in dampening the immediate payment shock that typically accompanies interest rate hikes.

in 2022 and 2023, fixed-payment variable-rate mortgages may have been instrumental in preventing a recession in Canada. When interest rates increased post COVID had all variable-rate consumers in Canada been subject to adjustable-rate mortgages, a real recession might have materialized severely impacting discretionary spending.

While these mortgages have postponed the payment shock to mortgage renewal, they have the impact of magnifying the problems down the road. Mortgages experiencing negative amortization will require even higher payments to cover the growing balance, potentially exacerbating the situation in the future when the five year term is up for renewal.

Despite concerns about potential long-term consequences, fixed-payment variable-rate mortgages have helped keep principal repayment lower than levels seen during the pandemic in 2020 when mortgage borrowers were granted payment deferrals. This is attributed to extended amortizations resulting from these static-payment variable mortgages.

In the broader economic context, these mortgages are considered among the top contributors to Canada’s economic resilience, complementing other factors such as pandemic-related savings and immigration. Their stabilizing effect on household debt-service ratios has been a significant factor in averting a recession and sustaining economic growth.

Effective Strategies to Address Negative Amortization

Addressing negative amortization is crucial to protect homeowners and maintain financial stability. Here are five effective strategies to mitigate the risks of negative amortization:

1. Increase Your Payments: Proactively increasing your monthly mortgage payments can help reduce the gap between your payment and the interest owed, effectively combating negative amortization. Lump sum prepayments and more frequent payments are viable approaches.
2. Convert to a Fixed-Rate Mortgage: Consider converting from a variable-rate mortgage to a fixed-rate mortgage to establish consistent monthly payments and protect against future interest rate hikes.
3. Refinance Your Mortgage: Refinancing allows you to obtain a new loan with more favorable terms, potentially reducing your monthly payments and addressing negative amortization.
4. Change Your Mortgage Terms: Adjusting the terms of your mortgage agreement, such as switching to a longer amortization period, can reduce monthly payments and mitigate the risk of negative amortization.
5. Seek Professional Advice: Consulting mortgage experts, financial advisers, or a Calgary mortgage broker can provide tailored guidance and assist in exploring suitable options to address negative amortization.

Conclusion

Negative amortization poses a significant financial risk to homeowners, particularly those with variable-rate fixed-payment mortgages. Understanding its causes and implementing effective strategies to address this issue is crucial for maintaining financial stability and preventing potential payment shock upon mortgage renewal. Seeking professional advice and staying informed about regulatory responses are essential steps towards mitigating the risks associated with negative amortization and ensuring a brighter financial future for Canadian homeowners.