You may know that every time the Bank of Canada raises the overnight rate/policy interest rate/benchmark interest rate, the commercial central bank will immediately raise the Prime Rate, but the monthly contribution of floating rate loans based on the prime rate that many people have already handled in banks (except Scotiabank) will not change. Why is this?
The reason why the monthly payment is unchanged is that the bank just adjusted the ratio of principal and interest in your repayment. The monthly repayment amount will be adjusted when the contract is renewed every five years. But what if the central bank keeps raising interest rates as it is now, and the principal in the lender’s repayment is not enough? Isn’t the commercial bank risky?
This involves an important concept: Trigger Rate, trigger interest rate. Before we talk about Trigger Rate, let’s review two common forms of floating interest rates, VRM and ARM.
The monthly supply of ARM(Adjustable Rate Mortgage) rises or falls with the benchmark interest rate. Many people will avoid this when choosing a loan, because once the interest rate is raised substantially, the monthly supply pressure will increase sharply.
The number of VRM(Variable Rate Mortgage) monthly payment remains unchanged, the interest rate rises, the interest ratio in monthly payment increases, the principal decreases and the repayment time becomes longer; If the interest rate falls, the total repayment time will change. As we said earlier, many people’s monthly floating loans have not increased with the central bank’s interest rate hike, which is the case.
But will VRM’s monthly payment figure never change? If the interest rate rises to a certain percentage or Trigger Rate, the monthly payment will be forced to increase, and the specific trigger opportunity will be mentioned in the initial loan contract. For example, a person who got a loan with an annualized interest rate of 1.2% last year may be required to increase his monthly contribution immediately when the floating interest rate reaches 3.95%.
Next, let’s talk about this Trigger Rate.
Trigger Rate has a rough calculation method: Trigger Rate= monthly payment X 12/ remaining principal.
In this formula, we can see that the denominator of the above formula becomes smaller as the monthly repayment reduces the principal, which leads to the gradual increase of the interest rate, so the Trigger Rate actually increases a little every month.
Of course, lending institutions have different methods to calculate the trigger interest rate, and what happens depends on your loan provider and personal situation.
When the interest rate is triggered by the continuous interest rate increase, that is, when the loan interest rate is higher than the Trigger Rate, it means that the monthly payment will not be enough to pay all the interest. According to the loan agreement, the bank can ask the lender to immediately increase the monthly contribution amount without waiting for the five-year renewal.
Let’s make a simple calculation with the loan amount of 1 million.
When the interest rate is 1.2%, the loan period is 25 years, and the principal and interest are paid equally:
Number of periods: 1
Total monthly payment: 3859.95
Monthly principal: 2859.95
Monthly interest: 1000.00.
If the loan term is 30 years, then:
Number of periods: 1
Total monthly payment: 3309.09
Monthly principal: 2309.09
Monthly interest: 1000.00.
When the interest rate rises to 3.95%, the 25-year loan period is:
Number of periods: 1
Total monthly payment: 5250.80
Monthly principal: 1959.14
Monthly interest: 3291.67
30-year loan period:
Number of periods: 1
Total monthly payment: 4745.37
Monthly principal: 1453.71
Monthly interest: 3291.67
It can be seen that in the case of a 30-year contribution period, the full amount of the contribution with the interest rate of 1.2% is close to the monthly interest when the interest rate is 3.95% (marked in red), thus triggering the interest rate.
Many people will avoid triggering Trigger Rate by prepayment or increasing monthly payment. And some people think that since it is better to improve the monthly supply early than late, why take up so much cash flow at one time.
At present, the central bank is raising interest rates violently, and those who get bargain-hunting floating interest rates in commercial central banks at the lowest interest rate may be asked by banks to increase their contributions immediately because the trigger interest rate is triggered recently. I would also like to remind all owners who use floating rate mortgages to check their Trigger Rate!
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