Canada’s housing market has always played a central role in the country’s economy. But with rising interest rates and declining home prices, the system is showing signs of strain. In its Annual Risk Outlook (ARO) for 2023, the Office of the Superintendent of Financial Institutions (OSFI) flagged several key threats that could ripple through the financial sector. At the heart of it all: a sharp drop in home values that puts both borrowers and lenders in vulnerable positions.

Variable Rate Mortgages and the Trigger Rate Dilemma

One of the biggest red flags OSFI raised is the growing risk surrounding variable-rate mortgages. When rates were low, many Canadians jumped at the chance to take advantage of lower payments. But those savings are starting to disappear.

With interest rates increasing rapidly, many borrowers have hit their “trigger rate” — a point where their fixed monthly payments no longer cover the interest portion of their loan. This results in their principal balance actually growing instead of shrinking. It’s a dangerous cycle that leaves homeowners owing more over time, and if housing prices drop, it gets even worse.

OSFI is closely watching liquidity levels in the market and has warned lenders to be prepared for increased volatility. While they aren’t predicting a full housing market crash, they are preparing for one.

Loan-to-Value (LTV) Ratios Are Creeping Up

The loan-to-value ratio, or LTV, is one of the clearest signals of risk in the mortgage world. It compares what a borrower owes on their mortgage to what their home is worth. A higher LTV means a riskier loan. And right now, many Canadian borrowers are tipping into dangerous territory.

After the Bank of Canada hiked its key rate from 0.25% to 4.5% in under a year, mortgage payments increased, and home prices fell. This double whammy has pushed many LTV ratios past 95% — meaning borrowers owe nearly their home’s full value. In some cases, the LTV has surpassed 100%, leaving borrowers underwater.

While defaults remain historically low, this rising LTV trend is a red flag for insurers. If borrowers start missing payments, insurance claims could skyrocket.

Mortgage Insurers Are Feeling the Pressure

Mortgage default insurers are supposed to be a safety net for lenders, covering losses if borrowers default. But the numbers they’re reporting are sobering.

Canada Guaranty disclosed that 5% of its insured mortgages had LTVs over 100% at the end of 2021. That’s a dramatic jump from just 0.74% a year earlier. Sagen, another major private insurer, had $14 billion (or 10%) of its insured loans above 95% LTV.

Even the crown corporation CMHC is seeing trouble. In Q3 2022, 2.8% of its insured mortgages had LTVs above 95% — double the rate from the previous year. These trends suggest a growing risk that could ripple across Canada’s financial system.

Stress Tests and the Trigger Rate Conundrum

Back in 2020, CMHC tried to tighten mortgage qualification rules with a stricter stress test, but it backfired and was reversed after market backlash. Looking back, this stricter approach might have prevented some of today’s risks.

Now, with rates rising, many borrowers are again facing strain. For variable-rate mortgages with fixed payments, once payments only cover interest, any unpaid interest is added back to the principal. That means the total loan balance increases, even if the homeowner keeps up with monthly payments.

The situation becomes even more critical at the “trigger point” — when the amount owed exceeds the original loan. Most lenders won’t step in until the LTV hits 100%, which may be too late.

Frequently Asked Questions (FAQ)

What is a trigger rate?
It’s the rate at which your variable mortgage payment only covers interest and no longer pays down the principal.

How do I calculate my trigger rate?
Use this formula: (Payment amount x Number of payments per year) / Mortgage balance x 100 = Trigger Rate.

Why are some mortgages unaffected by trigger rates?
Mortgages with adjustable payments (not fixed) rise along with prime rate changes, so interest and principal portions are recalculated regularly.

While falling home prices may signal relief for some buyers, they also highlight just how out of reach ownership still feels for many Canadians. Explore why one-third of Canadians believe they’ll never own a home — and what that means for the future of housing.

Final Thoughts

Canada’s housing market isn’t just about buying and selling homes – it’s the foundation of the financial system. With rising interest rates and falling home values, the pressure on borrowers, lenders, and insurers is mounting.

If you’re a homeowner, now is the time to review your mortgage terms and stay ahead of any changes. Understanding your trigger rate and your current LTV ratio can help you avoid nasty surprises. And if you’re thinking about entering the market, be sure to budget with rising rates and long-term equity risks in mind.

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