Negative amortization mortgages lead OSFI to makes changes

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Rising interest rates have helped to put a growing number of mortgage holders in the position where their loan balances are actually growing

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Canada’s federal banking regulator is preparing to make banks hold more capital against certain mortgages where homeowner payments fail to cover even the interest and the loan balance is greater than 65 per cent of the value of the property.

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Rising interest rates and the popularity of variable-rate fixed-payment mortgages have put a growing number of mortgage holders in this position where their loan balances are actually growing, a situation referred to as negative amortization.

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The Office of the Superintendent of Financial Institutions said such loans are riskier for banks and mortgage insurers and wants more capital held against them if the loan-to-value ratio is above 65 per cent, meaning the outstanding balance of the loan is greater than 65 per cent of the value of the property that is collateral for the loan.

“These changes will help banks and mortgage insurers address risks related to mortgages in negative amortization, where payments are insufficient to cover the interest portion,” OSFI said, adding that it will not affect monthly payments for consumers that have a current mortgage term.

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Under the proposed changes, negative amortization mortgages that breach the selected loan-to-value (LTV) calculation “will be treated as exposures that do not meet OSFI’s expectations set out in Guideline B-20” that regulates mortgage underwriting practices and procedures, OSFI said in a letter outlining its proposed changes, which are open to industry feedback through September 1, 2023.

“We believe this risk (resulting from negative amortization) is higher for mortgages with higher LTVs.”

In November 2022, the Bank of Canada noted that after steeply increasing the overnight interest rate from near zero at the start of the year to 3.75 per cent, about 50 per cent of borrowers with variable-rate, fixed-payment mortgages had reached a so-called trigger rate where set monthly payments covered only the interest, leaving the principal amount unpaid. Nearly 13 per cent of all Canadian mortgages were affected.

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In April 2023, the housing market topped OSFI’s annual list of the biggest risks to Canada’s financial system, with the variable-rate fixed-payment mortgage product a particular concern because the monthly payment doesn’t increase even as rates rise.

At the time, OSFI superintendent Peter Routledge said the short-term solution undertaken by many financial institutions and homeowners to simply extend the amortization period of the mortgage sets up borrowers for potential “payment shock” in two or three years when they must renew their mortgages. As the mortgage will typically return to the original amortization period, there would be a fairly significant increase in monthly payments at that time, he said.

The developments are particularly concerning if house prices — collateral against those growing loans — are falling.

Routledge said in April that the regulator was “preparing for the possibility but not predicting that the housing market will experience sustained weakness throughout 2023.”

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