The Bank of Canada has raised interest rates for the 5th time in 2022, on October 26. The overnight rate is now sitting at 3.75%. Back in January, it was 0.25%. With galloping inflation, the Bank of Canada made no secrets it would continue raising interest rates. Most economists believe the overnight rate will be 4% by the end of 2022.
An increase -or decrease- in the overnight rate impacts everyone’s finances, even those who don’t have a mortgage. The interests you pay on a line of credit or HELOC will adjust accordingly. Same goes for interests paid on various savings accounts and term-deposit instruments such as GICs.
If you have a variable mortgage, you could face a “trigger rate”. What is a “trigger rate”? Let’s find out.
If You Have a Fixed Mortgage…
This post doesn’t concern you. A fixed-rate mortgage isn’t impacted by a change in the overnight rate. If you’re interested, keep reading.
Mortgages 101
As a refresher, when you make a payment on your mortgage -whether fixed or variable-, a portion of it goes to the principal, i.e. equity builder, and the other goes to the bank in the form of interests.
When the overnight rate changes, your lender will either adjust your payment accordingly, i.e. increasing or decreasing it; or your lender will adjust your payment’s allocation, i.e. more or less will go towards interests and principal.
The latter is what can cause a trigger rate.
Variable Mortgages With Fixed Payments
More and more lenders offer variable mortgages with fixed payments, as they’re more convenient for both parties, and particularly lenders, of course.
As an individual, a fixed payment makes for easier budgeting and predictability. A fixed payment allows a lender to collect more interests in a rising rate environment…like now.
The challenge is that when rates raise, more and more of your fixed payment will go towards interests, and less and less will go towards the principal. Your amortization period will also become longer.
At some point, your fixed payment won’t be able to cover the interests accruing on your mortgage on a daily basis.
That’s when you’ll face a trigger rate.
Trigger Rate
When you reach your trigger rate, what’s actually being “triggered” is an increase to your balance owing. Any amount still owing is termed deferred interest and added to your balance to be paid later on.
How do I know when I’ve reached my trigger rate, you may wonder. A basic formula is:
(Payment amount X Number of Payments per year / Balance owing) X 100.
Each lender actually has their own methods, so you should confirm with yours.
If you reach your trigger rate, your lender will most likely call you and discuss your options. You can:
- Increase your payment
- Make a small -or big-pre-payment
- Switch your mortgage to a fixed rate
- A combination of the above
- All of the above
Trigger Rate vs. Trigger Point
The trigger rate isn’t the same thing as a trigger point.
A trigger point is usually when you owe more on your property than your property is worth. It’s commonly called “being underwater on your mortgage”.
Note that lenders have their own definition of what constitutes a trigger point. Being at trigger point spells out financial troubles. You really want to avoid being in this position.
Final Word
Rising interest rates have a real effect on variable-rate mortgages that could have lasting implications for your financial health.
The best way to manage the inherent risks associated with a mortgage is to keep on top of it. It’s not just about making payments, but also understanding how your mortgage works.
The Money Savvy Blog 