What is your trigger rate, and how does it affect your variable-rate mortgage?

What is a trigger rate?

A trigger rate is the interest rate level where your lender can adjust your payment amount, even though it’s normally fixed. The trigger rate applies to variable-rate mortgage holders that are on a fixed payment schedule.

Variable rate mortgages have trigger rates to ensure home owners are always building equity with their payments, especially as interest rates rise.

With a variable-rate mortgage, the amount you pay is usually fixed. What changes is the amount of your payment going to interest. This interest rate will be affected by the central bank’s.

Sometimes lenders lump variable-rate mortgages together with adjustable rate mortgages, which are different. With an adjustable rate mortgage the payments themselves increase or decrease due to shifting interest payments. With an adjustable rate mortgage — like a fixed-rate mortgage — there is no need to worry about a trigger rate.

Every lender has a different formula for calculating the trigger rate. Generally speaking, the trigger rate is when your interest payments exceed your total payments.

Let’s say you buy a home for $625,000 and have a down payment of 20% ($125,000). Your mortgage would be $500,000.

You now have a fixed payment variable-rate mortgage in January for 1.5%. You selected a five-year term with a 25-year amortization schedule. Your total payment for the five-year term would be $119,915.14, with $34,275.05 going to interest. Your monthly payment is $1,998.59.

The most important numbers in these scenarios are the total amount from scenario one ($119,915.14) and the interest from scenario two ($123,032.28).

If this were to happen, your monthly payment wouldn’t even cover the interest owed. In theory, your interest would be deferred. Even though you would be paying your mortgage, your balance would actually increase since the interest you’re not paying is being added to the balance.

That’s why there’s a trigger rate in place for variable-rate mortgages. It’s to ensure homeowners are always building equity.

More: What is the Bank of Canada's interest rate?

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How your trigger rate is calculated

Every homeowner with a variable-rate mortgage will have a different trigger rate since it’s based on your mortgage amount, monthly payment and interest rate.

The quickest way to determine your trigger rate is to review your mortgage documents. This would be the initial contract you signed. Your trigger rate will be clearly displayed, so you’ll know when to expect a call from your bank. That said, the trigger rate outlined in your documents assumes you haven’t made any prepayments. Every time you make a prepayment, it gets applied directly to your principal, so your trigger rate would increase.

For a more accurate number, you could contact your mortgage lender. They’ll be able to calculate your current trigger rate, so you’ll know how much breathing room you have.

Another way to calculate your trigger rate is to use the following formula:

(Payment amount X # of Payments per year / Balance owing) X 100 = Trigger rate in %.

If you have an outstanding mortgage balance of $500,000 with bi-weekly payments (26 payments per year) of $1,100. Your formula would look like this:

($1,100 X 26 / $500,000) X 100 = 5.72%

In this scenario, your trigger rate would be about 5.72%. Remember, every lender uses a slightly different formula to calculate your trigger rate, so you’ll want to contact them if you want an exact number. However, this formula is a reliable way to estimate yours quickly.

What happens when you hit your trigger rate?

When you reach your trigger rate, your lender will contact you with a few different options, so you don’t have negative equity with your payments. Generally, you’ll have the following choices available:

• Adjust your payment - Your payment will need to be changed, so at least some of it is going toward your principal. For example, if you were on a 20-year amortization schedule when you hit your trigger rate, your financial institution may advise switching to a 25-year amortization. This is a good option for those who already have equity in their home. If you’re already at the maximum amortization allowed, the lender would need to increase your monthly payment.

• Make a prepayment - The trigger is dependent on the remaining balance of your mortgage. If you make a lump sum payment, that would push your trigger rate higher. Alternatively, you could increase your monthly payments, so more money is going toward your principal. That said, your mortgage likely has specific rules about how many additional payments you can make.

• Switch to a fixed-rate mortgage - Your lender may allow you to switch to a fixed-rate mortgage without penalties. By doing this, you’ll lock in at current rates. While this strategy may give you peace of mind, it could cost you more in the long run. Plus, your monthly payments would increase.

• Pay off your mortgage - One final option you have to avoid your trigger rate is to pay off your mortgage balance. Of course, if you’re worried about your trigger rate, the odds are you don’t have enough cash lying around to discharge your mortgage.

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Try not to stress out

If you’re concerned about your trigger rate, talk to your lender now about your options. Alternatively, you may need to make some lifestyle changes. Cutting expenses or putting off major expenses could help your cash flow.

Those with small mortgages won’t be as impacted by increasing interest rates since they have equity built up in their homes. It’s new homeowners who have stretched themselves out to get into the market that will feel the pressure.