As many of you may be aware, the Bank of Canada increased the prime rate from 5.95% to 6.45% on Wednesday December 7, 2022. A move widely expected by economists, inflation remains prevalent on the global horizon, slowing economic growth in all hemispheres of the world. This increase will impact all debtholders, which includes those with mortgages to pay off – that is, those paying a variable rate mortgage.
With interest rates increasing, now is a great time to understand what a trigger rate is. A trigger rate is the rate at which your mortgage payment will only be covering the interest. Since your mortgage payments are often fixed in a variable rate plan, this means none of the payment will go towards paying the principal. This is a worse case scenario you should avoid at all costs – as you will essentially never be able to reduce the debt to your lender. The issue is that you will have stopped paying off your loan – this can also be called negative amortization. It is highly recommended that with this increase in interest that mortgagees figure out what their trigger rate is. This can be easily determined by reviewing your agreement, or contacting your financial institution and lender.
Let’s say someone recently obtained a mortgage for $1,000,000 with an Amortization period of 25 years. If this loan was taken out in January 2022, the prime rate would have been 2.45% and let’s assume their interest rate was the same. The monthly payments would be $4,454.80. However, if this mortgage was acquired in December 2022 the borrower would then be paying $6,667.96 each month, this is assuming their interest rate equals the current prime rate of 6.45%. This goes to show the extremely large impact the rising interest rate has had on debtholders throughout the year 2022. Assuming this interest rate were fixed for the next 25 years as compared to a 2.45% interest rate, a borrower would end up paying $663,945.99 more in interest payments.
As a mortgagee, rising interest rates are something you never look forward to. However, they are inevitable and are vital to the stability of the national economy. What can you do to make sure you don’t break the bank with monthly mortgage payments? There are a few viable options. Firstly, you can also ask your lender if they offer an interest rate cap – this is the maximum interest rate your lender can charge on a mortgage. This means you never have to pay more towards your interest than the cap rate, even if interest rates continue to rise.
Another option worth considering is making additional payments, which can be done two ways – increasing your monthly payment amount or making additional monthly payments . The key to saving money on your mortgage is to pay off your principal as quickly as possible. Your lender uses your mortgage payment to cover the interest first, before allocating it to your principal, and then your taxes and insurance in some cases. It’s important to note here that towards the beginning of your amortization period, only a small proportion of your mortgage payment goes towards your principal, though this gradually increases until your principal is paid off.
These complications make it more tricky to pay off your principal quickly, especially in times where interest rates are rising. Making extra and/or additional payments, if it is an affordable option for you, is a great way to combat this. Your lender will apply any extra payments under the terms of your mortgage towards the principal – reducing this amount can save you up to tens of thousands of interest dollars. However, this option is not advisable if you are racking up debts with higher interest rates – you should work towards paying those off before making additional mortgage payments. On that same note, it’s a good idea to adjust your budget if you decide to make additional monthly payments to balance out our other expenses. Ideally, you want to avoid resolving financial issues in one area of your life at the detriment of another.
The strategies discussed above also work well in the context of situations in which you reach your trigger rate. Though these are perfectly reasonable steps to take in these cases, we hope none of you get to this point – treating these solutions as preventative measures to avoid reaching your trigger rate is a best practice.
Variable interest rates are a constant part of our day-to-day life. Whether you’re a long-time multifamily property investor, an aspiring home owner, or a serial shopper, financial literacy is intrinsically important to making sure you get the best out of life. We all need to be ready for changes in the market – this could mean adjusting our monthly spending budgets and choosing a different time to make large transactions. As with most issues we encounter in our busy lives, it’s best to get in front of the complications in your mortgage payments and put in the work to mitigate it instead of working hard to recuperate from reaching your trigger rate.