Negative Amortization in Canada 🇨🇦
Table of Contents :
Negative Amortization.
How it works.
Risky Situation.
Mortgage Delinquencies.
OSFI Getting Strict.
What to do.
My Perspective.
Disclaimer.
In negative amortization, borrowers make minimum payments that don't cover interest owed, which is then added to the principal amount.
As a result, overall loan balance goes up, which is why Canadian regulators are worried, and us borrowers should be too.
Negative Amortization
When borrowers make minimum payments that don't cover interest owed, which is then added to the principal.
Amortization is basically the amount of time, required to pay off the mortgage in full.
When people exceed a trigger rate, bank adds the unpaid interest onto the mortgage amount.
Now inspite of borrower paying regular monthly mortgage payments, rather than mortgage balance going down, it keeps on creeping up.
Consequently, amortization period gets extended beyond regular 25 or 30 yrs, to much beyond that.
This is called negative amortization, which is worrisome both for banks as well as borrowers.
It is very evident, as rates have gone up very quickly in the last short while, amortization period have got extended too much.
How it works
Lets see how negative amortization works in real life situations.
On a mortgage of $100,000 at 2%, when amortized over 25 yrs monthly instalment is about $425.
Now rates are about 6%, making new payment as $640 pm, which is more than what you have contracted for, which banks can’t increase.
Therefore, this extra increased amount, the bank adds onto initial $100,000, thus increasing loan balance.
Surely, this can’t go in forever as both loan and interest have to be paid down, that too within a reasonable amortization period, which is 30 yrs max allowable in Canada.
At the end, borrowers have to make increased payments when their contract expires.
Risky Situation
Roughly one third of total, $1.5 trillion residential mortgages in Canada are variable rate, up 18% from pre-pandemic levels.
We don’t have 30 fixed mortgages like US, so we have to renew based on our term, max is every 5 yrs.
Latest report says, about 20% of all mortgages with six major banks in Canada, have amortization greater than 30yrs, that is up from about 2% an year ago.
BMO is topping the list with about 33%, CIBC with about 30%, TD with about 28%, RBC with about 25% of their mortgage portfolio, that has amortization of over 30 years.
This will increase mortgage delinquencies in my view, if not corrected timely.
Mortgage Delinquencies
As major banks are reporting increase in negative amortization for residential mortgages, the danger is very real.
Inflation is up again to 4%, so Bank of Canada will keep on increasing rates till inflation is below 2% target.
This will increase number of negatively amortized residential mortgages.
Already stretched borrowers may not be able to partially pay their mortgages, which could lead to bank taking them over and selling, thus creating a housing downtrend.
In such a scenario, even good borrowers will face problems.
The reason being, loan to value ratio will change that create a negative housing down cycle, like 2008 in the US.
Hope you get my point.
OSFI Getting Strict
When rates are going up, some variable rate mortgages have seen their amortization extended beyond, 60 or even 70 years.
Therefore, Canadian Federal Bank Regulator OSFI, will ensure that banks hold more capital against such overextended borrowers, in case of a default.
These forever mortgages could pose financial risks, if not checked now.
Increasing number of all mortgages are overextended, thus negatively amortized.
Regulator would want, lending less than 65% loan-to-value.
The situation could complicate further, as Bank of Canada is increasing rates, putting extra pressure on these over extended borrowers and banks.
Preemptively, regulator would start clamping down hard on banks, and borrowers will face challenging times soon.
What to do
I know people are stuck between rock and hard place, as far as negative amortization, and higher bank rates are concerned.
It is advised to pay down in lumpsum, both for borrowings or mortgage.
But in reality, reduced & uncertain incomes when rates are going up, make people’s life very tough economically.
Locking your mortgage for short term could be helpful, as more possible rate hikes are expected.
In both cases the main logic is, lower debt levels will incur relatively smaller or more affordable payments, which will even help your credit score.
Always anticipate an event before that occurs, while keeping an eye on macro economic environment.
My Perspective
I believe, there is to much overleverage in Canadian housing market.
No borrower wants to lose their house or rental property, but sinking real estate valuation will make life quite challenging for some borrowers.
This will not only change loan to value for borrowers, but with rate increase, repayments will become unaffordable.
In extreme cases, banks might start repossessing and then selling in the market.
This will create like what we saw in 2008 in the US, where we saw huge real estate correction, which I believe is overdue in Canada.
Now severity will depend upon, how steeply rate hikes will move.
Disclaimer :
As a disclaimer, I’m not a financial advisor please consult one before investing based on your personal financial situation.