fbpx

What is Reverse Amortization?

Unfortunately, we have been seeing these reverse amortization situations occurring more and more frequently so let's examine the scenarios where it happens and discuss what can be done about it.

What happens when you have a fixed payment variable mortgage and record rate increases?

Reverse Amortization

Most variable rate mortgage products at RBC, BMO, TD and CIBC are fixed payment variable mortgages.

If you took one of these before rates started increasing your interest costs will have skyrocketed but your payments did not.

This leads to your amortization (time until your mortgage is paid off) extending… also known as the dreaded “reverse amortization”.

Unless you increase your payments drastically you will have a drastic change to your payments at renewal (we will break this down at the end)

Left unchecked increasing interest rates and reverse amortization will lead to reaching your trigger rate.

What is Your Trigger Rate?

The trigger rate is the point where your mortgage payment no longer covers the interest you owe each month.

In other words the size of your mortgage actually starts to increase… paying your full mortgage each month only to see you owe more.

Scared, hopeless, heart breaking are a few of the emotions I have seen used to describe the situation.

I’ll do my best to break down what happens next for anyone in one of these products.

Here are the scenarios of what you could do before your renewal date

In a Worst Case Scenario – You do Nothing

If you took a $500,000 mortgage borrowed at 1.45% right before rates started to go up and made no increases to your payments (assumes variable rates average 6.2% for five years)

Mortgage     $500,000.00

Rate    P-1% (1.45%)

Payment     $1,711.56

Once rates started to rise if no changes were made to the payment the mortgage would quickly cross the trigger rate (the point where the payment does not cover all of the interest owed each month). This would cause the balance to start to increase every month.

By the 5th year the borrower could owe over $550,000, $50,000 more than the original mortgage!

Depending on the lender and overall circumstances (value of the home) the mortgage would quickly head towards the trigger point.

The trigger point is when bad things start to happen. The lender can require you to pay all excess interest ($50,000 in this case), or potentially increase your payments enough to get the amortization back on track (IE $1711 increased to $3642). Once the trigger point is reached your lender WILL force the issue.

You really do not want this to happen.

To keep control of the situation you will want to make sure you are proactive.

The Bare Minimum – Covering the Interest

Personally I suggest you make sure your payments cover 100% of the interest owed each month. If you are unsure what this is you can email me (keaton@kbmortgages.ca) your mortgage size and variable discount/rate (Prime – 0.5% as an example). I will let you know the interest you owe each month and the minimum payments you should be making.

If you cover all of the interest (in our $500,000 mortgage at Prime-1% (1.45% increased to 6.2%) the borrower would need to increase their $1711/m payment to $2583) you will owe $500,000 after five years.

Most lenders will be unhappy about the lack of mortgage debt paid off but are likely to leave you alone until your renewal date.

Below I will cover what happens at your renewal date. Don’t miss it because you need to know what will happen to your mortgage and payments.

The Best Case – Keeping your Current Amortization

For anyone that has the ability I suggest you do your best to keep your mortgage amortization (time until it is paid off) on track.

In the $500,000 example with a 6.2% rate today the interest owed each month would be roughly $2583 per month. To work towards paying off the mortgage in 30 years you would need to pay $3062 per month. For a 25 year mortgage the payment would be closer to $3283.

That is nearly double the original mortgage payment and may not be possible for everyone. If you need any help or have questions feel free to reach out to me and I will do my best to help.

What Happens to your Variable Rate Mortgage at Renewal?

Assuming you kept your mortgage from reaching the trigger point the rubber will meet the road when your mortgage renews.

Most lenders will require that your mortgage is brought back to it’s original amortization at renewal.

For those who took a 30 year mortgage with a 5 year term they will require your payments be set so you will pay off the mortgage in 25 years (from the renewal date).

Using our example mortgage here is what would happen at renewal if rates stayed at their current levels (prime 7.2%).

 

Mortgage $         500,000.00
RateP-1% (1.45%)
Payment $             1,711.56

 

Scenario 1: Letting the Mortgage Balance Grow

Assuming the lender did not force you to increase payments prior to renewal you would see your mortgage balance rise from $500,000 to roughly $557,000.

At renewal your $1711 payment would more than double, increasing to roughly $3642 (A 113% increase)

Scenario 2: Covering Only the Interest

At renewal your mortgage balance would be roughly $500,000.

Your original payment of $1711 would increase to roughly $3266. To cover the interest you would have actually been paying roughly $2583/m. Overall this is a 91% increase from your original payments.

Scenario 3: Keeping Your Mortgage on Track

If you had your payments increased to maintain your amortization your mortgage balance would be roughly $466,400.

At renewal your original payment of $1711 would increase to $3062. Keep in mind to keep your mortgage amortization ontrack you would have already increased your payments to around $3062 prior to renewal. Overall this is a 79% increase from your original payments.

I Don’t Know What to Do… Help

If you are unsure of what to do or are feeling stressed, confused or frustrated about this I can help you. My email is Keaton@kbmortgages.ca

Is There Anything I can do to Have Lower Payments at Renewal?


The short answer is yes but I need to be upfront. Not everyone will be able to do this due to qualifying getting harder. 

Not only do you need more than 42% mortgage income to qualify for the same mortgage but you must avoid these financing mistakes at all costs.

Taking on unsecured debt due to your increasing payments

$25,000 of credit card or line of credit debt is the equivalent to $100,000 on a mortgage, this means a relatively small debt can reduce your max mortgage borrowing power drastically.

In addition to qualifying for less your credit score can drop over 100 points if your revolving (credit card or line of credit) balances report over 50% of their total limit.

Allowing your balances to rise before renewal can eliminate your ability to lower your payments or to change lenders for a lower interest rate.

Taking on new loans (car, RV, boat etc.)

A $45,000 car loan at today’s interest rates reduces your max borrowing power by $100,000 on a mortgage! If you really need that new car it may be best to make sure your mortgage is dealt with before you buy it. Leasing and financing a car has the same reduction in the max mortgage you can qualify for.

Changing jobs, pay structure or starting a new business

If you start a new job, become a contractor or start a new business you may not qualify for your next mortgage.

A lenders (the ones with the best interest rates) are very picky about what income they will use in a mortgage application due to ever increasing government regulations.

Here are a few examples

 

  • Non guaranteed pay (bonuses, overtime, commission, non guaranteed hours) require a two year history to be used.
  • Contract work requires a two year history to be used. Not only do lenders want to see a long history of contract work, they can also be incredibly picky about what the wording is when it comes to the end of your contract. If it does not guarantee a renewal they may not recognize the income.
  • Starting a business or becoming a self employed “contractor”. Once again the magic two year rule appears with the additional requirement of wanting to see two years of tax returns filed so lenders can see what your income averages after business expenses (deductions).

My best advice is to reach out before you make any major career changes to avoid any financing issues.

Ahem… Lower Payments?

Sorry! Financing keeps getting more complex and keeping these short isn’t getting easier!

Before renewal you could reduce your mortgage payments by extending your mortgage amortization out to 30 years. This will require that you requalify and your mortgage does not exceed 80% of the value of your home (determined by an appraisal).

Here is what our example payments would look like.

Scenario 1: Letting the Mortgage Balance Grow

Your mortgage balance would have grown from $500,000 to roughly $557,000.

At renewal your $1711 payment would more than double, increasing to roughly $3642 (A 113% increase)

If we extend the amortization back out we could reduce your monthly payments to $3411.

Scenario 2: Covering Only the Interest

At renewal your mortgage balance would be roughly $500,000.

Your original payment of $1711 would increase to roughly $3266. (A 91% increase)

If we extend the amortization back out we could reduce your monthly payments to $3062.

Scenario 3: Keeping Your Mortgage on Track

If you had your payments increased to maintain your amortization your mortgage balance would be roughly $466,400.

At renewal your original payment of $1711 would increase to $3062. (A 79% increase)

If we extend the amortization back out we could reduce your monthly payments to $2856.

Nothing is For Free in This Life

By stretching out your mortgage payments to the maximum amortization you will reduce your payments by roughly 7%.

This 7% reduction in your payments will increase your total interest cost by nearly 20% and mean making payments for an extra five years!

I know times are challenging, we saw our mortgage payment double over the last two years and it is happening all over Canada.

If you feel lost or need help I can help you understand your options and figure out what to do next.

A Final Word on an Article Way Too Long

One aspect I did not consider was rates falling from their current levels. I do believe that interest rates will fall but I do not know when (nor does anyone for sure). We may get lucky and see interest rates drop quickly or we may see them stubbornly hold on for far longer than we would like.

Historically speaking we have seen interest rates increase substantially almost twenty times since the 1960’s. On average rates will rise for eighteen months, sit at the peak for four months and then begin to fall.

That being said there have been a few periods where rates have risen for years and the speed that interest rates drop can vary drastically.

My advice is to hope for the best but plan for the worst.

If you are struggling with higher interest rates I strongly suggest you be as proactive as possible.

I hope with all my heart rates come down soon but I cannot say I am certain of it. Nor can I say how much rates will actually come down.

The best advice I can give you is to be honest with yourself, make sure you understand your current situation and know what changes will happen to your mortgage over the next few years.

Know that you are not alone struggling with higher rates and I will do my best to help, all you need to do is ask.

I have to be upfront though, I will not suggest private or B mortgages to simply buy you time. If there is not a way to solve your challenges I will likely suggest you consider selling your home.

I don’t say this to be cruel or because I do not care. Rather I do not want to see anyone peddled “hope” in the form of incredibly high interest costs where you burn the equity you have to keep your home for an extra few months.

I will do everything I can to help you but I won’t sugar coat things. In my opinion it is better to sell your home and walk away with money in the bank rather than delay an extra year and sell with nothing left.

If you need help let me know and I’ll do my best for you.

Find out more

As mortgage brokers we are on your team. Our job is to understand your needs, plans and wants in order to understand your mortgage needs. We then look at a number of lenders to find the best products and solutions for you.

During our time in the industry we have learned a number of tips and tricks to help you save money and to pay of your mortgage faster.

If you have any questions or would like a customized mortgage plan let us know!

You might also enjoy