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Canada’s banking watchdog warned that many homeowners who took out mortgages when rates were near zero during the pandemic will soon face a reckoning as those loans renew.

The “payment shock” faced by some borrowers is among the most important risks currently in the financial system, according to the latest risk outlook from the Office of the Superintendent of Financial Institutions, released Wednesday.

The regulator said that 76% of outstanding residential mortgages as of February will be coming up for renewal by the end of 2026. Most worrisome are the 15% of mortgages that have variable rates with fixed payments. Some of those loans are negatively amortizing — that is, the regular payments no longer cover the full interest costs because rates have gone up so quickly, so the principal balance is increasing.

Eventually, those borrowers have to make lump-sum payments or accept much higher monthly outlays, the regulator said.

“We expect payment increases to lead to a higher incidence of residential mortgage loans falling into arrears or defaults,” OSFI said.

Housing risks have been a longstanding concern for Canada as households contend with high home prices, elevated interest rates and inflation levels eating more of their take-home pay.

The report added that the labor market remains relatively strong, but any weakness may change the risk landscape significantly.

The Bank of Canada’s benchmark overnight lending rate has been at 5% since last July, the highest level in more than two decades. That’s crucial because many Canadians have mortgages with interest rates tied to the central-bank rate. The longer rates stay elevated, the more those households will be dealing with financial strain.

OSFI’s report also raised security risks from hostile foreign actors, wholesale credit and liquidity as potential problems in the system. The regulator said it was concerned about financial institutions’ security and integrity being under attack by fraud and money laundering.

The regulator plans to address foreign-interference concerns through a new group given the task of ensuring that banks and other financial institutions address threats to national security.

Source: Yahoo Finance / Bloomberg