Canada’s economy has so far managed to avert recession and shrug off the fastest rate-tightening cycle in the nation’s history.
And one of the key reasons for that is due to the prevalence of fixed-payment variable-rate mortgages, which experts say have cushioned borrowers from the full impacts of the Bank of Canada‘s rate hikes.
Fixed-payment variable rates, which are offered by banks such as RBC, TD, BMO and CIBC, mean the borrower’s monthly payment remains the same as rates increase, while the portion going towards interest costs rises and the amount going towards principal repayment decreases.
“There’s no question in my mind that these [fixed-payment] variable-rate mortgages are the reason that there is no recession today,” Ron Butler of Butler Mortgage told CMT.
“If every single variable-rate consumer in Canada had an adjustable-rate mortgage like those offered by Scotiabank and National Bank [where payments fluctuate as rates change], we would have a real recession on our hands right now,” he added. “Discretionary spending would have been radically, radically cut back by now.”
Not only have these types of mortgages postponed the payment shock to when these borrowers renew their mortgages, but they’ve actually “magnified the problems down the road,” says Ben Rabidoux of Edge Realty Analytics.
That’s because any mortgages that have gone into negative amortization, where payments aren’t sufficient to cover the principal portion and the mortgage starts growing, will need to see payments increase even higher to account for that difference, Rabidoux explained.
“So now you’re amortizing a larger balance over a short period of time,” he said. “You can make the argument that we’ve softened the blow in the near term, but have made it worse down the road.”
One of the best illustrations of what has happened is the following chart that breaks down current household debt-service ratios.
Rabidoux notes that principal repayment has dipped lower than levels that were seen during the pandemic in 2020 when hundreds of thousands of mortgage borrowers were granted mortgage payment deferrals by their lenders.
“That is entirely due to these static-payment variable mortgages, which are extending amortizations,” he explained, in turn lowering the principal repayment component.
But when you look at the interest portion, “it’s as high as it’s been in 50 years,” Rabidoux points out. “So, Canadians are feeling that to the full extent, yet because the principal repayments have fallen so much, that kind of softens the blow.”
One of multiple factors contributing to a resilient economy
Canada’s economy has so far continued to outperform expectations in the face of the Bank of Canada’s rate hikes. In the Bank’s own forecasts, while it expects GDP growth to slow in the coming year—1.2% annualized growth in 2024 following an expected 1.8% growth rate in 2023—it currently expects the country to skirt a recession.
While Rabidoux doesn’t believe fixed-payment variable mortgage products are solely responsible for the surprising strength of the economy, he puts them among the top three contributors.
“I would say first off was pandemic-related savings, which are still very high. And I think that everyone, myself included, underestimated just how large that pile was,” he said. “The second I would say is immigration. When you’ve got a 3% tailwind from population growth, the economy by default is growing 3% just to stand still.”
In the second quarter alone, the working-age population surged by 238,000, the largest quarterly increase on record, according to Statistics Canada.
“Third is absolutely the structure of the mortgage market, for example these fixed-payment variable-rate mortgages,” Rabidoux said.
Will fixed-payment variables be available in the future?
It’s no secret that regulators have set their sights squarely on mortgage underwriting, which has the potential to impact the availability of fixed payment variable-rate mortgage products.
Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), singled them out in its Annual Risk Outlook for 2023-2024.
“…we are actively assessing the risks posed by variable rate fixed-payment mortgages to determine whether the current capital treatment is fit-for-purpose or [if] revisions are warranted,” OSFI said back in April.
In response to questions for this piece, OSFI told CMT that while it does “not regulate specific mortgage products and cannot comment on the broader economic implications of specific products offered by select institutions,” that it nonetheless “expects that all mortgage lending by federally regulated lenders follow prudent underwriting standards and sound risk management practices.”
In July, OSFI announced proposed changes to the capital requirements that would impact the country’s lenders and mortgage insurers. Under the proposed guidelines, lenders will be required to hold more capital that aligns with the increased risk of mortgages in negative amortization with a loan-to-value ratio (LTV) above 65%.
And in January, OSFI unveiled proposed changes to its guideline B-20, which governs mortgage underwriting. Those proposed debt serviceability measures include loan-to-income (LTI) and debt-to-income (DTI) restrictions, debt service coverage restrictions and interest rate affordability stress tests.
“We are carefully reviewing the submissions received as part of this consultation and expect to issue a summary of stakeholder feedback and next steps in the fall,” OSFI confirmed to CMT.
So, what does this mean for the future of fixed-payment variable-rate mortgages in Canada? Some, like Rabidoux, believe their days could be numbered.
“I think that there’s a chance they’ll be more expensive because banks will have to bake in the additional cost of compliance related to it. The underwriting will be tighter at a minimum,” Rabidoux said. “And I think there’s a chance that they’ll just disappear altogether.”