Interest-rate cuts to smooth over analysts’ “mortgage renewal cliff” awaiting pandemic homebuyers

Many homeowners who will be renewing their five-year mortgages for the first time next year may be worried about a steep increase in their monthly payments. But faster and larger than expected interest-rate declines promise to reduce what analysts had dubbed the “mortgage renewal cliff” into something more akin to a hill.

 

Growing concern about the health of the Canadian economy is raising the odds of a bigger-than-usual interest-rate cut by the Bank of Canada in October, according to investors and economists. With several more reductions expected this year and in 2025, some forecasters see the central bank’s trend-setting rate falling to 3 per cent or even lower by the next summer, down from its current level of 4.25 per cent.

 

A rapid decline in borrowing costs would shrink the gap between the exceptionally low mortgage rates that many homeowners secured in 2020 and 2021, during the early stages of the COVID-19 pandemic, and the higher rates available that many of those borrowers will have to sign up for in 2025 and 2026 when their loans roll into a new term.

“Now that we’re in the midst of a relatively rapid rate-cutting cycle, we believe mortgage renewals will be much more manageable,” Royce Mendes, managing director and head of macro strategy at Desjardins Securities, said via e-mail.

 

But borrowers with a five-year mortgage term ending in the next couple of years are still in for a rough ride ahead, with the average homeowner expected to pay hundreds of dollars more a month after renewal, according to Mr. Mendes.

 

Consider a borrower who bought their first home in July, 2020, for $571,500 – equal to the average national home price at the time – with 10-per-cent down, a competitive 1.89-per-cent five-year fixed interest rate and an amortization of 25 years to pay off the loan in full.

With a down payment of less than 20 per cent, this homebuyer would have had to pay for mortgage insurance, which protects the lender if the borrower defaults. Accounting for that additional cost, the homeowner had an initial mortgage balance of $530,295 and a monthly payment of $2,217, according to calculations by Ratehub.ca, a financial-products comparison site.

 

Assume the Bank of Canada’s benchmark rate falls to 3 per cent by July, 2025, a decline that would also, indirectly, affect fixed rates offered by mortgages on new and renewing loans.

 

In such a scenario, the borrower may be able to sign up for a new five-year fixed rate below 4 per cent, according to Ratehub. At 3.9 per cent, their payment would rise by just under 20 per cent to $2,655, or $438 more a month.

 

A mortgage instalment increase of that size would be sizable but not crippling for most homeowners, said Penelope Graham, a mortgage expert at Ratehub.

 

That payment bump is roughly in line with simulations run by Mr. Mendes and Tiago Figueiredo, macro strategist at Desjardins. Homeowners renewing five-year fixed-rate mortgages in 2025 face a monthly payment increase of 25 per cent on average, they estimate. Based on the average mortgage payment in Canada at the end of 2023 – $1,600, according to government data – that would work out to an increase of roughly $400 a month for fixed-rate holders.

 

But the bigger concern is about borrowers with variable-rate mortgages, according to Mr. Mendes. These are the homeowners who took out loans with rates that tend to rise or fall after movements in the Bank of Canada’s key rate but have payments that normally remain the same through the length of the mortgage term.

 

When rates increase, lenders typically apply a larger portion of the instalment to the interest charge than the principal, which lengthens the time it would take a borrower to extinguish the loan.

 

But when the central bank jacked up interest rates by a cumulative 4.75 percentage points over the course of 2022 and 2023 to fight inflation, many variable-rate mortgages reached the point where the full payment went to just paying interest. Some borrowers even saw their mortgage balance grow, as lenders added any part of the interest not covered by regular instalments to the principal amount.

 

Homeowners in that predicament were typically forced to increase their payments, make lump-sum contributions to their mortgage or both.

 

In addition, stretched-out amortizations usually snap back to their original lengths when the loans are up for renewal, a factor that can compound any increase in monthly payments owing to homeowners signing up for higher interest rates.

Still, some borrowers who tackled those rate increases aggressively may find that their payment won’t change much at renewal if borrowing costs fall significantly by next summer, according to Ratehub’s calculations.

 

For example, take a first-time buyer who bought a home at the national average home price in July of 2020 with 20-per-cent down, a 25-year amortization and a 1.95-per-cent variable rate.

 

Even after bumping up their monthly payment by 20 per cent in the fall of 2022 and another 10 per cent in the summer of 2023, this homebuyer would end their first five-year term with an effective amortization of just over 22 years, instead of the expected 20 years.

 

But a steep decrease in borrowing costs between now and the summer could spare them a further payment increase at renewal. If they renewed with another five-year variable rate at 3.95 per cent, their monthly payment would be $2,513, slightly lower than the $2,541 a month they were paying at the end of their term, according to Ratehub.

Still, for many variable-rate holders, rate cuts won’t be nearly enough to flatten the renewal cliff, according to Mr. Mendes and Mr. Figueiredo.

 

For those renewing mortgages with five-year variable rates this summer, Mr. Mendes and Mr. Figueiredo expect an average payment increase of 42 per cent, or around $700 on a $1,600-a-month instalment.

 

Borrowers worried about their upcoming renewal can work with a mortgage broker to explore options such as refinancing their loan to extend the amortization or reduce the principal with a lump-sum payment to keep instalment amounts in their financial comfort zone, Ms. Graham said.

 

“You would have to crunch the numbers for your specific scenario,” she said.

 

 

 

This article was first reported by The Globe and Mail