By Chris Warner, FCSI, CIM, CFP, PFP
Mortgage payments likely to change considerably for Canadians
“…Comparing a variable rate mortgage from May of 2021 to the conditions anticipated in January 2023, a home buyer who expected 65% of their payments go toward building home equity would now find themselves with 75% of their initial payment covering the interest costs.”
Historically, variable rate mortgages have mostly offered better value for Canadians than those with fixed rates. However, with the rapid increases of interest rates and more increases on the horizon, variable rates may be losing some luster. Assuming a Canadian bought an average-priced home one year ago and opted for a variable rate mortgage, let’s explore where they would be now, then analyze where they might be headed in a year’s time.
According to the mortgage calculator at WOWA.ca, the average Canadian home sold for $690,598[i] in May 2021. To capture what that might look like on a relatable level, let’s imagine that someone owns this average home with a conventional variable rate mortgage. For the exercise, we’ll assume this mortgage entails a 20% down payment and 25-year amortization period with a variable rate of Prime (2.45% as of May 2021 as per Bank Prime Rate) minus the discount rate (0.70% as of May 2021), equaling 1.75% at the time. The total mortgage then would have been $552,478 with a monthly payment of $2,273. For the initial payment, $791 (35%) would have gone to interest and $1,482 (65%) would have gone to principal.
Prior to the increase on July 13, 2022, the Bank Prime Rate had increased to 3.70% after our May 2021 scenario, meaning the variable mortgage rate would have been 3.00% (an increase of 1.25% total from the May 2021 example rate of 1.75%). Assuming the homebuyer holds the same variable mortgage, their monthly payments would not have increased as a result of the interest rate change, but the amount of their initial payment allocated towards interest would. As such, , $1,364 (60%) of their initial payment would be allocated to interest and $909 (40%) to principal.
While it’s hard to speculate on a developing issue, a polling of some economists prior to July 13, 2022 indicated that there could be two further rate hikes this year of at least 50 basis points (BPS). As of July 13, the Bank of Canada rate increased another 100bps, which suggests that prime rate may increase even further than originally thought. If the predicted future rate increases take place and the banks follow suit by increasing their own prime rates, that would put the bank prime rate at 4.70% by year’s end (as opposed to the 2.45% from our original May 2021 scenario).
If we return to our mortgage example, under the new conditions prior to July 13, the mortgage rate would increase to 4.00%— a considerable hike from the 2.25% we started at. With monthly payments of $2,273, a “trigger rate” clause in the mortgage would likely come into effect, forcing an increase in these payments, because otherwise, the payment amortization would have such a low principal allocation that the mortgage would exceed 35 years’ repayment—the maximum amortization time period for Canadian mortgages. As a result, payments would need to increase by $162 per month, to a total of $2,435. In this scenario the initial mortgage payment would be allocated as $1,815 (75%) to interest and $620 (25%) to principal, a notable shift from the original projections.
In summary, comparing a variable rate mortgage from May of 2021 to the conditions anticipated in January 2023, a home buyer who expected 65% of their initial mortgage payments go toward building home equity would now find themselves paying an extra 7% each month, with 75% of their total initial payment covering the interest costs. More importantly, they would add roughly ten years to the amortization of their mortgage, an increase in duration of the mortgage of 40%.
This case study points to what may be a common scenario for many Canadians who purchased a home in the last year. These rate changes will also impact anyone with floating rate debt. As such, it stands to reason that anyone with variable-rate debt might want to spend some time with their financial planner to see how rising rates are affecting them and to forecast what the further implications might be, along with how to best address them.
[i] As shown in Figure 1, housing prices were 3% lower in May 2021 than June 2022. Therefore, for our example, we used 97% of $711,316 = 690,598.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities commissions.