Introduction to Canadian Variable-Rate Mortgages, Fixed-Rate Mortgages, Mortgage Insurance, and HELOCs

Types of mortgages and mortgage insurance in Canada. They differ from the US mortgage market.

This introduction to the complexities and risks of Canadian mortgages, HELOCs, and mortgage insurance is based on two comments posted on Wolf Street by longtime commenter “Some Guy.”

Types of mortgages in Canada:

5-year fixed-rate mortgage, very common. The rate is fixed for 5 years, and then you have to renew, at which point the interest rate is reset. If you stay with the same bank, and are up to date on your payments, you won’t have to get re-approved at renewal; they will just roll into whatever new term you agree to. If you want to change your interest-rate terms (fixed vs variable, or length of term) before the 5 years is up, you have to pay a fairly hefty penalty, sometimes worth it, sometimes not.

One-year, two-year, three-year, or four-year fixed rate mortgages (less common than the 5-year fixed) often have a better rate than a 5-year fixed (the fixed rates are linked to the bond yield curve, so depending on the shape of the curve, anything from one to five years might be the best deal in the eyes of a borrower at any given time).

Longer than 5-year fixed-rate mortgages are rare and very expensive (high rate). In the US, the typical mortgage is a 30-year fixed rate mortgage, which is practically non-existent in Canada.

5-year variable-rate mortgage (not quite as common as 5-year-fixed). The interest rate paid is linked to the “bank rate,” one of the policy rates of the Bank of Canada (BoC), and goes up or down as the BoC raises and lowers rates.

Variable-rate mortgages come in two types:

One, the payment amount adjusts as rates go up or down in order to maintain a steady rate of principal repayment (keep amortization period the same), leading to higher payments as rates go up.

Two, the payment amount does not adjust as rates go up or down, but the bank adjusts the principal portion of the repayment, so that the overall payment amount stays the same. When rates go up, the amortization period stretches out. If rates go up a lot, as they have recently, borrowers will hit their “trigger rate,” meaning they aren’t paying any principal at all any more, and are in “negative amortization.”

In these cases, most banks have been extending the amortization period, rather than increasing the required payments, and that is why you see the amortization periods blowing out as banks delay the hit to the borrower (and their delinquency statistics) from the rising rates. Falling principal repayment has offset the rising interest repayment so that overall borrower payments haven’t risen as much.

This delays the impact, but borrowers will still get hit with the full payment shock when they renew their mortgage (i.e. when their 5-year term ends). In the meantime, very little principal is getting repaid so debt levels remain high.

Variable rates v. fixed rates: The gap between a variable and fixed rate varies depending on the yield curve in the bond market.

In the year or so before rates started to climb, short-term rates were very low and fixed rates were quite a bit higher, so there was a huge gap in rates, with variable rates much cheaper, and borrowers piled into variable-rate mortgages (at all-time record high prices). That meant when rates started to go up, a lot of people were hit immediately.

It is possible to get a mortgage that is “open” instead of “closed,” meaning that the borrower pays no penalty to change the terms. But this type of mortgage comes with a very high rate, and is typically offered for a short term (e.g. 6 months). This is used mostly if the borrower is stalling for time and hasn’t been able to settle on what rate to choose when their mortgage expires or is temporarily stuck between selling one property and buying another (bridge financing).

The “amortization period” is distinct from the “term.” Historically, most Canadian mortgages were 25-year amortization. Recently 30-year amortization has become more common. As described above, many variable-rate mortgages are now effectively on a much longer amortization period until their 5-year term is up, at which point the amortization will need to be reduced to at most 30 years – in theory at least, unless banks and/or OSFI (Canadian banking regulator) allow longer than 30-year amortization at time of renewal as a borrower relief measure.

HELOCs in Canada.

Home Equity Lines of Credit (HELOCs) are common and many banks have them set up as combined loans, so that as the borrower pays down their term mortgage over time, the limit on the HELOC increases so that the loan to value ratio on the mortgage doesn’t decline.

Because of this added risk, HELOCs are limited to 65% loan to value ratio, and aren’t eligible for insurance. But there are still a lot of them out there; and in a severe price decline, they would add to the volume of underwater properties, especially in cases where people are using a HELOC as down payment on another property, or using the HELOC to make payments on their term mortgage and so on.

HELOC’s are always variable rate, almost always interest only (no principal repayment required), and do not have a term or amortization, they just get reviewed internally by the bank every now and then.

When housing & mortgage problems arise in Canada.

Canadian market is hit much faster and harder by rate increases than the US market, especially, in 2022/2023, because such a high percentage of the market was in variable-rate mortgages when the rate increases started.

But at the same time, banks have been allowing amortizations to (temporarily?) extend past traditional norms in order to delay the full impact of the rate increase.

Two waves of defaults. Historically, rate increases cause two waves of increases in delinquency/defaults for banks:

The first wave is caused by people unable to pay the higher rate, and this wave is typically smaller and more concentrated in the sub-prime parts of the market. Prime borrowers usually have enough slack in their finances to be able to suck it up and pay the higher rates.

The second, bigger, wave comes as a second order impact, as the rate increases slow the economy, that leads to layoffs, and prime borrowers start to default when they lose their job. But this process takes years.

Underwater. The other factor to watch is the percentage of borrowers that are underwater. Canada (outside of Alberta, and Saskatchewan to some extent) has recourse mortgages, meaning a borrower can’t simply send jingle mail and walk away from the house. But borrowers can still declare bankruptcy in other provinces to get out from under an underwater property.

And they are still prevented from solving cash flow problems by simply selling their property if they are underwater.

Mortgage insurance in Canada.

The law requires that if a borrower makes a down payment of less than 20%, the borrower (not the bank) has to pay a premium to buy insurance for the bank.

The insurance premium gets rolled into the borrower’s mortgage payments so that they pay off the premium over the course of the amortization of the mortgage.

In case of a default by the borrower, the bank can get the insurer to cover any shortfall (with certain limitations, e.g. around the maximum legal fee that can be covered, etc.).

The bank can either sell the property first and go to the insurer for the leftover balance, or in some cases, give the property to the insurer to sell, and take a full repayment of the mortgage up front.

The insurance is provided by one public insurer and two private insurers:

  • Canada Mortgage and Housing Corporation (CMHC) which is 100% backed by the Federal Government of Canada
  • Sagen, formerly owned by GE and known as Genworth, now owned by Brookfield
  • Canada Guaranty, backed by the Ontario Teachers Pension Fund).

Even where the mortgage insurance is through the private insurers, the government still backstops almost the entire loan, with the exception of a deductible (equal to 10% of the initial insured amount at time of origination) which could be lost by the bank if the private insurer was to go bankrupt.

The last time there was a severe downturn in the Canadian housing market (early 1990s), the private insurer at that time, Mortgage Insurance Company of Canada (MICC) went bust, and the government arranged a bailout with GE picking up the pieces.

So the federal government is on the hook for the highest loan to value ratio (LTV) mortgages most likely to be underwater in a downturn – and not the banks.

In addition to the insurance purchased by the borrower at time of origination for low down payment (high LTV) mortgages, the banks themselves can also take portions of their loan book and purchase insurance themselves from CMHC. Typically they do this so that they can securitize their mortgage book (i.e. sell it to 3rd party investors). Because of the CMHC insurance, the mortgages can be sold for a better price as the credit risk is minimized for the purchaser with the loans being backed by the Federal Government.

During the 2008-2009 downturn, as a low-key banking bailout, the government allowed banks to purchase insurance for huge chunks of their mortgage book. But the government got a little nervous about the size of their exposure and limited somewhat the volume of this kind of “bulk” or “portfolio” insurance purchases from CMHC.