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Canada’s banking regulator says the sustained increases in interest rates over the past 18 months have challenged some borrowers’ ability to pay and led to a deterioration in certain credit quality.

In the fall update to its Annual Risk Outlook, the Office of the Superintendent of Financial Institutions (OSFI) said borrowers with variable-rate, fixed payment (VFM) mortgages have been most impacted by the the Bank of Canada’s 475 basis points worth of rate tightening to date.

OSFI says its among this group of borrowers where it’s seen a deterioration of credit quality, particularly in cases where the borrower has reached their trigger rate and is no longer paying down any of their loan’s principal.

While this causes the amortization period to extend, OSFI stressed that it’s only temporary, until the mortgage term comes up for renewal.

“In fact, the contractual amortization period does not change,” OSFI said. “And mortgagors will have to make up the deferred principal paydowns when they renew. This means they are at risk of suffering a significant payment shock.”

Borrowers will be tested

While OSFI noted that Canada’s lending institutions remain well-capitalized, it said mortgage borrowers will be tested in the coming years in this new higher-rate environment.

“As the impact of higher rates continues to be absorbed, the ability of consumers and businesses to adapt to the current rate environment will be tested as loans mature over the next few years…” OSFI’s update reads.

“We remain vigilant and continue to monitor for indications of increased borrower defaults, increased fraud, credit losses, and any broader credit led softening of the economic environment,” it added.

Feedback on proposed underwriting changes to be released Monday

In its fall update, OSFI also confirmed that on Monday it will publish comments from its public consultation period held in response to new underwriting rules the regulator first proposed in January.

The measures focus on debt serviceability, and include changes such as loan-to-income thresholds that it says will help financial institutions “better manage the risks associated with significant buildups of household debt in their loan books.”

Another proposal would see OSFI adopt more “risk-sensitive” tests of affordability beyond the current Minimum Qualifying Rate (currently 5.25%) used in the existing mortgage stress tests.

This could see lenders implementing varying MQRs based on different risk characteristics and product types, such as different mortgage terms.

“OSFI seeks an integrated set of common-sense protections that work effectively both in a high interest rate environment like today, and when interest rates are low as they were during the pandemic,” the regulator noted. “Our primary aim is to ensure that Canadian homeowners can afford to service their mortgages in good times and hard times.”

Source: Canadian Mortgage Trends