Canada’s federal banking regulator is expressing concerns about a deterioration in credit quality. In an update to its Annual Risk Outlook, the Office of the Superintendent of Financial Institutions singles out variable-rate, fixed payment mortgages as a key concern.

As the name suggests these mortgages, known as VFM, have a fixed payment that does not change even as interest rates fluctuate. The portion of the payment that is applied to interest and principal changes. In more traditional variable-rate mortgages the actual amount of the payment could change as interest rates move up or down.

OSFI has been concerned about VFMs for some time and has been working on policies to resolve those concerns. The regulator points out the VFM borrowers have been impacted the most by the Bank of Canada’s rising interest rate policy.

OSFI says a sustained period of interest rate increases can push VFM loans beyond their “trigger rate”, which means the fixed payment is not enough to cover even the interest portion of the loan.

“If rates rise beyond the trigger rate … the mortgage principal outstanding grows. There is a common misperception that these mortgages’ amortization period extends … In fact, the contractual amortization period does not change. And mortgagors (i.e. borrowers) will have to make up the deferred principal paydowns when they renew. This means they are at risk of suffering a significant payment shock,” OFSI says in its report.

Proponents of VFMs say the loans have helped soften the blow of rising interest rates by deferring any increase in payments. If rates had not risen so high, or been in place for so long that could have helped with a soft landing for the economy. But most now recognize that VFMs will only offer temporary relief.

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