Understanding Negative Amortization: A Savior or a Time Bomb?

Today, let's explore the concept of "negative amortization," a term frequently encountered in the mortgage and real estate markets. Is it a financial savior or a hidden threat?

This discussion arises from the argument that Canadian housing prices haven't dropped significantly because only about 35% of households have mortgages, with the majority either mortgage-free or renting. According to this perspective, even with rising mortgage rates, only a small portion of households are affected, limiting the overall impact on the real estate market.

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However, this viewpoint overlooks how market prices are actually determined. Real estate pricing is unique because it involves the valuation of a small "increment" (the available supply) relative to a large "stock" (the total quantity held by various entities). In simple terms, prices in the real estate market are driven by the minority of properties that are for sale, not the majority that are held off the market.

With this in mind, let's delve into why Canadian housing prices haven't seen a significant drop. The main reason is that there hasn't been a substantial increase in the number of properties available for sale, and we haven't seen widespread panic or forced sales. This stability is largely due to banks extending the amortization periods for mortgage borrowers, resulting in what is known as "negative amortization."

Mortgages are long-term loans typically structured over 25 to 30 years. Payments are calculated based on this period under the assumption that interest rates will remain stable. However, in Canada, unlike in the U.S., most mortgage terms are 5 years or less, with a significant number being variable-rate mortgages. This means that any adjustment to the central bank's overnight rate directly impacts these mortgages. When rates rise, borrowers may find themselves paying more in interest than they originally anticipated, leading to a situation where they might struggle to meet their payments.

In the current rate-hike cycle, many households have experienced sharp increases in their mortgage interest, sometimes surpassing the amount they can afford. Strict adherence to the original mortgage terms could result in homeowners defaulting, leading banks to repossess properties. This would flood the market with distressed sales, potentially triggering a market crash similar to the 2008 financial crisis.

To avoid such a scenario, many banks have opted to keep monthly payments unchanged, adding any unpaid interest to the principal and thereby extending the loan term—this is "negative amortization." While this strategy prevents forced sales and keeps the supply of available properties limited, it has also meant that housing prices have not experienced significant declines.

Among Canada's major banks, only Scotiabank and National Bank do not allow negative amortization. This policy has resulted in a higher number of foreclosures from these institutions, particularly in the Greater Vancouver area. Meanwhile, the other major banks, such as RBC, TD, CIBC, and BMO, have varying levels of exposure to negative amortization, with percentages ranging from 24% to 30%. This ratio indicates the proportion of mortgages with amortization periods exceeding 30 years, which is considered a sign of negative amortization.

However, it's important to recognize that negative amortization is not a cure-all solution. While it temporarily alleviates the pressure on homeowners, it ultimately increases their debt burden. Adding unpaid interest to the principal creates a compounding effect, leading to higher overall costs in the long term. This "interest on interest" scenario can trap borrowers in a cycle of escalating debt, much like the character Xi’er in the Chinese folklore who became the infamous "Bai Mao Nu" (the White-Haired Girl) due to her overwhelming debts.

In conclusion, negative amortization may prevent an immediate market collapse, but it also delays the inevitable reckoning. Homeowners may find themselves facing even greater financial challenges down the road, and the housing market could still be at risk if this issue is not addressed proactively.