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  • Frank Tian

🏠 Higher Rate to Trigger Rate

🟧 Higher Rate - To Be Higher

Bank of Canada (BoC) raised the rate by another 50 bps in Oct - the cumulative hike is 350 bps this year.

Then the Fed raised 75 bps in Nov. That means BoC is likely to hike more in Dec.

Canada imports many merchandises including groceries from the US in the winter.

🟦 Variable Rate - Popular at the Wrong Time

The fastest rate hike puts max pressure on variable rate mortgage holders.

A variable rate means the mortgage rate fluctuates with the prime interest rate.

It is a good choice if the interest rate will remain low - as in the past decade.

It is not a good choice if the interest rate will rise fast - as this year.

However, many were drawn to the variable rate in 2021, because it was lower than the fixed rate.

With the same $ monthly payment, a lower rate under variable rate allows consumers to afford more expensive houses.

That partly explains the skyrocketing Canadian property price during the pandemic.

In comparison, the US does not have such a variable rate. Even the closest ARM (Adjustable Rate Mortgage) locks the rate for the first 3+ years.

In the 2nd half of 2021, 53% of mortgage originations in Canada were at a variable rate, per CMHC.

The average rate at origination was 1.6%~ (See Graph).

🟨 Trigger Rate - Being Triggered

The majority of variable rate mortgages have fixed payments - easy for consumers to manage cash flow.

Risk is created when a variable rate is matched with a fixed payment.

It is possible the payment is not enough for the interest newly accrued, when the rate reaches a certain point.

That threshold rate is called the “Trigger Rate”.

It signals the existing payment arrangement will lead to “Negative Amortization” - the payment is not enough to cover the new interest. Unpaid interest will be added to the principal.

To avoid negative amortization, consumers need to increase their payments - either by a larger regular payment or a lump sum payment.

To address the risk of the higher rate, all borrowers were required to pass a stress test under a hypothetical rate at origination - which was 5.25% last year.

This covers the 1.6%~ at origination + 350 bps increase so far = 5.1%.

However, the remaining room is not much.

The rate hike hasn’t stopped.

Graph Source: Ben Rabidoux at Twitter

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