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Here’s what you should know about extended amortizations and why many people are facing an “affordability disaster.”
Published on Oct 10, 2023 • Last updated 14 hours ago • 4 minutes reading time
Canadians could face significantly higher mortgage payments if interest rates don’t fall. Photo by Getty Images/iStockphoto
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Rising interest rates are putting more pressure on variable-rate mortgage borrowers, sometimes extending their payback periods by decades – at least on paper. But are people really being given 70, 80 or even 90 years to pay off their homes? The Financial Post’s Ian Vandaelle explains what you need to know about extended repayments and how rising interest rates affect mortgages.
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What exactly is a payback period and how does it differ from a mortgage?
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Essentially, your mortgage and the payback period are two different ways of looking at the path to the same goal. Your five-year mortgage is a contract that sets out the interest rate you have agreed with your bank for the next five years. But very few people are able to pay the entire cost of a house in such a short period of time. This is where the payback period comes into play – this is how long it would take to pay off your mortgage in full at the pace you choose. Typically, the payback period in Canada is 25 years, a value that is a mandatory cap if you make a down payment of less than 20 percent.
While home buyers can choose shorter payback periods that come with higher monthly payments, Canadian lenders typically don’t offer 30-year paybacks, even with a 20 percent down payment. The 25-year amortization therefore remains the rule.
For mortgage contracts, however, five years is the standard, which means you renegotiate your interest rate with your lender every half decade. If you stick to your original repayment plan and interest rates don’t change, you would take out five five-year mortgages – 25 years – before paying off the house in full.
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However, each time you renegotiate, you can also tinker with the payback period, essentially moving the goalposts to a point in time when you are likely to be debt-free.
It is worth noting that not every country does it this way. In the United States, homeowners can sign a full-payment mortgage agreement of 25 or 30 years.
If the cap is 25 years, why are we now hearing about paybacks of up to 90 years?
So here’s where it gets a little strange: These borrowers don’t actually have nine decades to pay off their mortgages, on paper it just looks that way. The vast majority of variable-rate mortgage borrowers — about three-quarters of them, according to the Bank of Canada — have fixed-payment mortgages. In these cases, your monthly mortgage payment is static. However, when interest rates rise, the portion of the monthly payment that goes toward paying off principal decreases and the portion that goes toward interest increases. The less principal you pay back, the longer your effective payback will take, and that’s the calculation that appears on mortgage statements and makes headlines.
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But as I said, it’s a paper change. If your contract term is up and you need to renegotiate with the bank, the amortization period will revert back to a more normal term, says Rob McLister, mortgage planner at FixedOrVariable.ca and editor of MortgageLogic.news.
If your contract term has expired and you need to renegotiate with the bank, your extra-long payback period will revert to a more normal term. Photo by Getty Images/iStockphoto
“Once the mortgage expires, the lender you remortgage with will typically adjust your payment to get you back on track to your contractual repayment,” he said. “So if you start with a five-year mortgage and a 25-year amortization, and the “on paper” amortization increases to 70 years, then when you renew in five years, your new payment would be based on a 20-year amortization. This assumes that you have not made any additional payments or refinanced your debts.”
Why is this all happening?
Essentially, this is due to a change in interest rate dynamics in response to the pandemic. It’s been a roller coaster ride, both because of the Bank of Canada’s rapid cut in its key interest rate during the worst of COVID-19 and the most aggressive rate hike cycle in the bank’s history to try to curb inflation. In the former case, lower interest rates encouraged more borrowers to take out variable-rate mortgages because, at least at first glance, they looked cheaper. According to a Bank of Canada study, the number of variable-rate mortgages topped 50 percent in early 2022, surpassing the share of fixed-rate mortgages that had been the dominant option in previous years.
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However, because variable mortgages are variable, they could change when interest rates and five-year bond yields rose, increasing the amount of the monthly mortgage bill for the interest.
What happens next?
This all depends on when your mortgage renewal is due. The early days of the pandemic saw a surge in home sales and therefore mortgage originations, meaning plenty of renewals are coming in 2025 and 2026. If interest rates have moderated by then, the blow to homeowners could be softened.
But McLister warned that without such a scenario, Canadians could face significantly higher payments.
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“Higher interest rates and repayment cuts at maturity are a affordability disaster for some people,” McLister said. “That’s why there’s so much concern about rolling over payments in 2024 to 2026. If interest rates don’t go down, many people will see their payments increase by 35 to 50 percent or more.”
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