What is a Trigger Rate and How to Avoid it

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What is a trigger rate? It’s a question that many homeowners thought they’d never have to ask. However, since the Bank of Canada has steadily raised interest rates, it’s a topic that has crossed the minds of many.

If you have a fixed-rate mortgage, there’s no need to worry about a trigger rate since your payments will remain the same regardless of what happens with interest rates. However, if you’re on a variable-rate mortgage, you could have hit or might soon hit your trigger rate, which is why you need to understand what a trigger rate is and how to avoid it.

What is a trigger rate?

A trigger rate is when your regular mortgage payments no longer cover the interest. Essentially, you’d be building negative equity, which obviously doesn’t help you or your lender. 

This happens in a rising interest rate environment and only affects fixed payment, variable-rate mortgage holders. For those affected, every time your lender’s prime rate increases, more of your payments get applied to interest and the amount applied to the principal decreases. If rates keep rising, you’ll eventually hit your trigger rate. Those on an adjustable-rate mortgage (ARM) would not be affected, as their payments would adjust whenever there are any interest rate changes.

How to calculate your trigger rate

The quickest way to determine your trigger rate is to check your mortgage contract. When you signed, your trigger rate would have been listed in the paperwork. 

While the number in your documents would be accurate, it obviously wouldn’t factor in any changes since then, such as prepayments or adjustments to your payment schedule. To get the most updated calculation, you should ask your lender.

It’s also possible to calculate your trigger point manually. Although every lender may use a slightly different method formula to determine what is a trigger rate, you can use the following formula: 

(payment amount x number of payments per year / balance owing) x100= trigger rate %

For example, let’s say your mortgage balance is $500,000, and you make monthly payments of $2,500.

($2,500 x 12/$500,000) x 100 = 6% trigger rate 

Many people don’t want to hit their trigger rate since it will increase their mortgage payments. However, it’s there to protect you. If your interest payments are going up, your paying less toward your principal. That means it’ll take you longer to pay off your balance.

What happens if you hit your trigger rate?

Once you get near your trigger rate, your lender will likely contact you and present you with a few different options. This is actually an ideal scenario because the last thing you want is for your lender to suddenly increase your payments once you hit your trigger point. That could shock your finances, so your other options may be better.

Increase your payments 

The most typical solution is to increase your payments. Depending on how quickly rates have gone up, the amount you may need to pay could increase significantly. The key thing to understand is that lenders require your minimum payment to cover the interest payments and a little bit of principal. In some cases, you might need to extend your amortization to keep your payments affordable. For example, you might need to switch from 20 to 25 years. It’s worth noting that mortgage loan insurance providers have told lenders that those who are insured (anyone with less than a 20% down payment) can go to an amortization schedule of up to 40 years (the maximum amortization number).

Make a prepayment 

Since your trigger rate is dependent on the balance of your mortgage, any prepayment would increase your trigger rate. Making a lump sum payment would help the most since the entire payment is applied to your remaining principal balance. You could also change to a more frequent payment schedule, such as advanced bi-weekly, but that only goes so far. It’s also worth noting that most mortgages have set rules about prepayments. You can typically only prepay a certain amount in any given year.

Switch to a fixed-rate mortgage

Most lenders will allow people on a variable-rate mortgage to switch to a fixed rate with no penalty. Since fixed-rate mortgages have a set payment schedule, there’s no trigger rate to worry about. This is the solution many people have gone with since it gives them a few years of certainty, but your monthly payments would still increase since you’re locking in at current interest rates.

Pay off your remaining balance

If you have no mortgage, there’s no trigger rate to worry about. The problem is most people don’t have the funds available to simply pay off the balance and have their mortgage discharged. Even if you did, you still need to consider any prepayment penalties that you would have to pay.

How rising interest rates affect monthly payments

For nearly a decade, Canadians were told that low interest rates were here to stay. For those that bought a home in 2021 or early 2022, the standard advice was to go with variable mortgage rates since it’s cheaper.

Now that we’ve seen multiple rate hikes, there’s been a real impact on the lives of many borrowers. Those on a fixed-payment, variable-rate mortgage may not have noticed a difference immediately, but consider someone on an adjustable-rate mortgage.

Let’s say they have a $500,000 mortgage with a 25-year amortization schedule. Their monthly payments would be as follows:

  • 2% interest rate – $2,117.26
  • 3% interest rate – $2,366.23
  • 4% interest rate – $2,630.10
  • 5% interest rate – $2,908.02
  • 6% interest rate – $3,199.03

As you can see, if they started with a 2% variable-rate mortgage and saw a 4% increase (which has already happened), their monthly payments would have increased by more than $1,000. While this increase would have hurt, they’ve had time to adjust with each increase rate announcement.

Those on a fixed-payment variable-rate mortgage would not have seen these changes until their trigger rate was hit. Can you imagine getting a call from your lender and being told you need to increase your payments by $1,000 a month? There’s a good chance you would panic.

How to avoid your trigger rate

Now that you know what is a trigger rate and what options you have, you can make an informed decision.

When interest rates rise, your lender’s prime rate changes. The reality is that many people who signed up for a fixed-payment, variable-rate mortgage in early 2022 are approaching or have already hit their trigger rate. In an ideal world, you want to contact your lender in advance to discuss your options. 

The simple solution is to make some prepayments so your trigger rate increases. If you’re unable to do so, you should speak to your lender or your mortgage broker to see what solutions are available. Switching to a longer amortization period may not be ideal, but if it helps you stay afloat for the time being, it’s a reasonable solution.

About Barry Choi

Barry Choi is a Toronto-based personal finance and travel expert who frequently makes media appearances. His blog Money We Have is one of Canada’s most trusted sources when it comes to money and travel. You can find him on Twitter:@barrychoi

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