The Decibel - When paying your mortgage doesn’t reduce your loan

Episode Date: March 15, 2023

Since the Bank of Canada started hiking its benchmark interest rate just over a year ago, there’s a growing number of mortgage-holders with monthly payments that no longer cover the principal or even the interest portion of their loan.Rachelle Younglai covers real estate for The Globe and she recently reported that at CIBC, 20 per cent of mortgage-holders are seeing their loan balances grow instead of shrink. This represents $52-billion worth of mortgages. CIBC isn’t the only bank in this situation but it’s the only one that’s disclosing this information.Rachelle is on the show to explain why this might be a cause for concern and what mortgage-holders should be thinking about.Questions? Comments? Ideas? E-mail us at [e-mail]

It wasn't part of their main presentation. It wasn't part of their investor presentation. It wasn't in any of the bullet points when they released their financial earnings. It was just part of this table. The Globe's real estate reporter, Rachel Younglai, recently found a very important piece of news in a quarterly report for one of Canada's major banks. At the bottom of CIBC's table, amortization table, there was a footnote. It basically said that $52 billion were negatively amortizing. A negative amortization means that the amount of money people owe for their original loan goes up instead of going down, even when

they're making their regular monthly payments. You're essentially going backwards when you're trying to pay down your loan. Today, Rachel's on the show to explain how and why this is happening and what it could mean for your mortgage and Canada's housing market. I'm Maina Karaman-Wellms, and this is The Decibel from The Globe and Mail. Rachel, thank you so much for being here today. Thanks for having me. So we're going to be throwing into a lot of bank lingo today, and we'll make sure we break down what it means. But let's just start with the basics here.

When someone gets a house with a mortgage, they basically get a loan from the bank and then set up a repayment plan. And we're talking about the amortization period here. Can you just give us the very basics of what an amortization period is? Like, yeah, what does that mean? It basically means the amount of time it takes for you to pay down the original loan plus the interest because you're charged interest for borrowing this money. So that's basically what it is, the length of time it will take you to pay down your mortgage. And in Canada, the amortization period is normally 25 to 30 years. Why is that the usual time frame? It's the usual limit because the bank regulator

doesn't want you to have a loan that extends for a long period of time, or they don't want to give you a definite number of years to pay down your loans. And has it always been that way? Or was there a period where we gave out longer mortgages? Yeah, there was a period where we did have longer amortization periods. But that was scaled back because the Government of Canada did not want homeowners to have these very long amortization periods where they were just paying a very fraction amount of their principal. And who sets these rules, Rachel? So the finance department, as well as the office of the superintendent of financial institutions, also known as OSFI. Okay. So regulators, essentially, that's a government agency as well. Regulators, yeah.

Okay. And then just one more thing to explain before we actually get into what you're reporting found here. We're going to be talking specifically about variable rate mortgages. Can you just briefly explain what that is? So a variable rate mortgage is a mortgage where the interest rate changes based on the Bank of Canada's overnight lending rate. So the Bank of Canada's benchmark interest rate. In Canada, the most popular type of variable rate mortgage is a mortgage that has a fixed monthly payment. So your payment stays the same every single month. And that has never been truly tested until this past year when we've seen interest rates go up

as much as they've gone up. So I would say that when people think variable rate, they think, oh, okay, it changes with the Bank of Canada's benchmark interest rate. And so my monthly payment should go up every time they raise interest rates. But this product that we have in Canada does not change every time the Bank of Canada raises interest rates. It stays the same. The monthly payment stays the same. Okay. And that, of course, is something that we've been paying attention to this last year because we've seen it dramatically increase from 0.25% to now 4.5%. So that's a dramatically increase. So that will affect people with variable rate mortgages. Yes, correct. It's such a big increase,

going from 0.25% to 4.5%. Just the magnitude of that increase over such a short period of time is huge, in less than a year. And I know it's low, 4.5% is very low compared to the 80s when we're in double digits and 20%, but it's still just the magnitude found in your reporting, Rachel. CIBC's most recent financial statement had in a footnote that 20% of their mortgage holders are making monthly payments that aren't even touching the principal and aren't even covering all of the interest that they're paying here. And if these mortgage holders are signing up for a 25 or 30-year loan repayment plan, what's happening to their loan, I guess, in the long term? So for the variable rate mortgage holders, the length of time it takes for them to pay off the entire loan is being extended. It's lengthening. So if they took out a 25 year variable rate mortgage, the amortization period is going beyond 25 years. It's going beyond 30 years. Okay. And so I guess let's just break this down to really look at how this happens. So if you've

got a mortgage and let's say you've got a variable rate mortgage, you're paying $5,000 a month or something for your mortgage. Can you break it down what that $5,000, I guess, would cover maybe a year ago or two years ago and what it covers now? Sure. Okay. So say two years ago, you were paying less than 2% in interest on your mortgage and say you were paying, I don't know, $3,000 towards your principal and 2,000 towards your interest. But as the Bank of Canada raised interest rates, more of your monthly payment, more of your $5,000 monthly payment would go towards interest and less towards principal. So, I don't know, say after several interest rate hikes, you could be paying $3,000 towards interest and $2,000 towards your principal. And then getting to a point where now interest rates are 4.5%. For this example, none of your payment would go towards principal reduction, towards reducing the size of your

original loan, and all would go towards interest. But in the case of what was happening with CIBC and other banks, we have some mortgage holders, some variable rate holders whose monthly payment, so that $5,000 payment that we're using as an example, it's not covering even all of the worried if they have a variable rate mortgage. Do banks warn people that their payments aren't making a dent in their principal and maybe in fact aren't even covering their interest? Are people notified that this is happening? In some situations, if you are getting to the point where your monthly payment is not going to be covering any of your principal reduction, the bank will call you or send you a letter and say, you're getting close to this, they call it a trigger rate, this trigger where you have to increase your monthly payment.

So in some cases, they do. In some cases, you are allowed to add some of that interest onto your mortgage, the size of the loan, and you're not alerted until you reach a certain threshold. And then they will tell you, okay, not only are you not covering any principal, these interest payments are increasing, and now you have to increase the size of your monthly payment. Okay. So some banks will notify you with that trigger rate, but sometimes you won't actually get that notification until you're already adding a lot more money onto that.

Yes. The amount of money you have to pay is really going up then. Yeah. So basically what's happening is that, so the interest that you're not covering is then being deferred and added to the original size, your original loan size. And so when you come up to renew your mortgage, usually you have to do that every few years in Canada. Do you see a change at that point? Yes, that's when you see a change. When it comes up to renew your mortgage, usually to the contract, the loan contract, you should have paid down five years of the loan. So you have only 20 years to pay down the rest of your loan. But because during this period, your interest rates have gone up dramatically and you're paying less towards principal, that means that you are trying to shrink,

bring your amortization period back now, not just to 25 years, bring it down to 20 years. And that means that your payments are going to be a lot higher. And do we know right now how much more a person might pay? So there are estimates out there. I mean, it depends for every borrower, it depends on the size of their loan, when they took out their loan, what kind of interest they've been paying. I mean, a rule of thumb is that it's a 50% increase over the period of the past year, with interest rates going up by 4.25 percentage points. In some cases, we're seeing, I've spoken to mortgage brokers who have said that some of their clients are seeing their payments go up by $1,000 or $1,500 per month. So it's significant.

What if you can't pay that? Like that could be a big jump for people. Can they extend the length of time? So yes, that is a big jump for people. A lot of households can't just come up with an extra $1,000 every single month to make their mortgage payments. So at that point, you can try to do a refinancing, which is basically taking out a new mortgage. And you could try to go back to the original terms of the loan. So go back to 25 years.

Okay, so you started with a 25-year mortgage. You had it for five years. You're back to a 25-year mortgage. So you're getting a 30-year mortgage. You had it for five years. You're back to a 25-year mortgage. So you're getting a 30-year mortgage essentially. Some mortgage brokers are talking to their clients about trying to find extra cash to come up to try to reduce the overall size of the loan so they can reduce the size of their monthly payments. Or some of them have told their clients, oh, well, you might have to downsize or maybe try to find a renter. I mean, there's lots of discussions happening right now on what to do. I would also say that we are not really seeing the true impact of these interest rate increases quite yet.

I mean, even though it's been a big increase, some people won't know or won't see how much more they have to pay until it's up when they have to renew their mortgage. Can you just help me understand, Rachel, like if there are rules in Canada around amortizations getting too long, how is this allowed to happen? It's a function of the product. And because it's a fixed monthly payment, it's the way the product works. We'll be back in a minute. So is there any limit to how long these amortization periods can run for? Like 35, 40 years, more than that?

So it's not clear from the disclosures that the banks made in their quarterly results how long they are. All we know is that they're above 30 years, that they have a large portion of their residential loan book is above 30 years. This time last year, no bank had any of their variable rate mortgage borrowers did not have an amortization over 30 years. They were at zero, all of them. Zero. Yeah.

And then if we look today, or as I mean, the most recent results came out in January, between 25 to just over 30% of their loan book has an amortization over 30 years. Is that a concern for the banks? Well, they say it's not because everyone renews at different periods and they're monitoring their loan book. So we've been talking about CIBC here. So of all the home loans that CIBC provides, how much money are we talking about specifically this context of when people are making payments and it's not even covering the interest? It represents $52 billion according to their disclosures. $52 billion. And do we know their total residential loan portfolio?

Yes, it's $263 billion. Okay, so $52 billion of $263. Yes, exactly. So that's CIBC, but what do we know about the other banks? How many people are banking with them who are making mortgage payments that don't cover the interest. So BMO and TD also have a similar product that allows you to shift some of your interest to your principal when your fixed monthly payment isn't enough to cover all of your interest portion on the payment. But we don't actually know how much the dollar amount or how many borrowers are in that position where their monthly payment is not able to cover all of their interest payments.

So the other banks aren't even, this could be happening, but they just aren't talking about it essentially. They haven't disclosed it. Yeah. Yeah. I mean, we asked them, they haven't disclosed it. So we don't know. Okay. Yeah.

It's actually difficult to put it into context because CIBC is the only one that disclosed this information. And when I spoke to analysts about whether this is a high amount or if it appeared high, they said, yeah, it seems high, but we don't really know. I mean, if CIBC is an outlier because the other banks haven't disclosed the same information, that we have no idea. So this, I mean, this could potentially mean that a lot of people might be facing financial stress in the coming months and years. And it does make me and probably other people think about the 2008 financial crisis, when so many people in the US defaulted on their mortgages because they couldn't afford to pay. Should we be worried about something like this happening? Like are there are there safeguards in place to ensure that there aren't mass mortgage defaults? If you have made a down payment that's less than 20%, you have mortgage insurance, which means that if you can't make your payment, then the bank is not going to lose money if you default on your mortgage, if you have mortgage insurance. I mean, one way to see if homeowners are able to make their payments is to look at mortgage defaults. So whether you're behind on your payments.

And when you look at the mortgage default rate for Canada, it's 0.15%. So it's very, very, very low. And it's even lower than during the financial crisis when it was 0.45%, which is not high either. From that, we can tell that people are making their mortgage payments. And I would say that in Canada, paying your mortgage is the priority for most homeowners because in Canada, the lender, the bank is allowed to go after all of your assets if you don't make your mortgage payments. So unlike the US, where you can walk away from your home if you don't make your mortgage payments, that's not the situation here. So people are very, very, very motivated to pay their mortgages. So it's the last thing that people will default on. Thank you so much for being here

today, Rachel, and for helping explain this complex topic. Thanks for having me. Before you go, The Globe wants to hear from you about how the pandemic has shifted your priorities. We want to hear about the big and the small changes that you've made. So send us an email at audience at globeandmail.com. That's audience at globeandmail.com. That's audience at globeandmail.com. That's it for today. I'm Mainika Raman-Wilms. Our producers are Madeline White, Cheryl Sutherland, and Rachel Levy-McLaughlin. David Crosby edits the show. Adrian Chung is our senior producer, and Angela Pachenza is our executive editor. Thanks so much for listening,

and I'll talk to you tomorrow.