Interest Only Mortgage in Canada
What You Should Know
- Interest only residential mortgages are subprime mortgages only offered by alternative lenders.
- By the end of its term, an interest only mortgage can be paid back, rolled over into a normal mortgage or refinanced.
- Interest only mortgages are attractive because of their lower monthly payment.
In an interest-only mortgage, as the name suggests, installments only include interest on the principal and no payment of the principal itself. This means much smaller monthly payments. But such a mortgage would face a number of complications on the lender's side.
In any mortgage, real property is used as collateral to borrow money. Canada's regulation allows a lender (like a Canadian bank) to lend as much as 95% of the real property’s value. But when a lender is lending more than 80% of the real property's value, they must insure that mortgage against the borrower's default.
Mortgage insurance requirement for mortgage loans with a loan-to-value (LTV) ratio greater than 80% is imposed by the Bank Act, Trust and Loan Companies Act, Insurance Companies Act, and Cooperative Credit Associations Act.
Typically every mortgage has an amortization period. In other words, the borrower is expected to pay installments which, in addition to the interest, include a part of the principal borrowed. The principal part of the payments is good for the borrower because it increases the borrower's equity in their home. It is also suitable for the lender because it reduces the loan-to-value (LTV) ratio and thus decreases the risk of the mortgage.
Residential Mortgages
Mortgage insurers like CMHC only insure loans with a maximum amortization of 25 years. Since an interest-only mortgage does not pay down the loan's principal, it does not amortize. So such a mortgage cannot be insured. Even if you make a down payment of 20% or more and opt for an uninsured mortgage, no federally regulated financial institution (FRFI) can offer such a mortgage.
Canadian law requires that the Office of the Superintendent of Financial Institutions (OSFI) regulate FRFI. OSFI aims to limit the risk to financial institutions and thus reduce the likelihood of their failure. OSFI is also mandated to maintain public confidence in the Canadian financial system.
Since residential mortgages are an important part of the business of FRFI, OSFI has issued Guideline B-20, which details what it expects of FRFIs concerning residential mortgages. In Guideline B-20, each FRFI is mandated to have a residential mortgage underwriting policy (RMUP). In RMUP, FRFI is expected to determine the maximum amortization for residential mortgages it underwrites.
As a result, an interest only mortgage can only be offered by an alternative mortgage lender. Alternative lenders include credit unions, B-lenders, monoline lenders and private lenders. Alternative lenders are not obliged to perform a stress test as OSFI does not regulate them. Yet an interest only mortgage does not satisfy the amortization requirement of mortgage insurers. Thus one can’t insure an interest only mortgage against default. This means that you would need a minimum of 20% down payment if you plan to purchase a house with an interest only mortgage.
The point is that with an interest only mortgage, your home equity does not increase (assuming other conditions like the state of the housing market in your area and the longevity of your house stay the same). This means that, unlike a regular Canadian mortgage, the risk of an interest only mortgage does not decrease with time. This higher risk means that you would have to pay a higher mortgage interest rate.
Also, suppose at the end of your interest-only mortgage term, you roll over into a conventional mortgage. In that case, all the interest you have paid during the interest only period is extra money out of your bank account.
The most likely reason for a person looking for an interest-only mortgage is that they have difficulty handling installments of a conventional mortgage. Thus at the end of the interest only term, they likely would have trouble either just paying back their loan or handling larger payments from turning an interest only mortgage into a conventional mortgage.
Is the interest-only mortgage a good option?
Because of the significant risk related to refinancing at the end of the interest only term, in most situations, it is best to avoid an interest-only mortgage. If you have difficulty qualifying for a mortgage in which installments include both the principal and interest, the ideal solution would be to increase your earnings. Still, the most practical solution is to look for a house with a smaller price tag.
One situation where an interest-only mortgage would make sense is when a home sells significantly below its market value, either because the seller needs cash in a hurry or because the house requires some repairs. This is much more likely to work out profitably if you are experienced in house repairs. In such situations, by selling the house after performing repairs, you would likely make a profit large enough to quickly make up for the higher interest rate of an interest-only loan.
The next best thing to not using an interest only mortgage is to ensure your mortgage has prepayment privileges and that you are using those privileges.
Comparison of Interest Only with Conventional Mortgages
Below, we compare two scenarios; in both, a buyer is purchasing a $500k home with a $100k down payment. In the first scenario, they start with a five-year interest only mortgage and then transition to a conventional 25-year mortgage, while in the second scenario conventional 25-year mortgage is used from the onset.
We assume that they qualify for a conventional mortgage at a rate of 5% while they qualify for an interest only mortgage at a rate of 6%. These two scenarios are summarized in the following table.
| Scenario 1 | Scenario 2 | ||
|---|---|---|---|
| Principal | 400,000 | Principal | 400,000 |
| Interest Only Annual Rate | 6% | Interest Only Annual Rate | 6% |
| Conventional Mortgage Rate | 5% | Conventional Mortgage Rate | 5% |
| Interest Only Term in Months | 60 | Interest Only Term in Months | 0 |
| Amortization Period in Months | 300 | Amortization Period in Months | 300 |
| Monthly Conventional Rate | 0.00416667 | Monthly Conventional Rate | 0.00416667 |
| Interest Only Monthly Installment | $2,000 | Interest Only Monthly Installment | $2,000 |
| Conventional Monthly Installment | $2,338.36 | Conventional Monthly Installment | $2,338.36 |
The following column chart compares annual payments for the scenario with an initial interest-only mortgage and the scenario without the interest only mortgage.
Annual Payment vs. Year
As you can see in the first scenario, over the first five years, your monthly payments are lower by $338.36. This translates to $4,060 lower payments each of the first five years. The price you would pay is monthly payments of $2338.36 between the 26th and 30th year. In other words, in order to pay $20,300 less over the first five years, you would have to pay $28,060 per year between the 26th and 30th years.
Commercial Mortgages
Interest-only mortgages are more reasonable and more common when it comes to commercial properties. Especially for residential real estate, the property might be in need of renovation after purchase. So it is reasonable to want a smaller mortgage payment during the initial renovation. After that, the property's cash flow increases, and thus its ability to make larger mortgage payments is not in question.
Thus in the case of commercial mortgages, it is even possible to insure a mortgage which includes an initial interest only mortgage term. Note that CMHC only considers insuring a commercial mortgage if the majority of the underlying property is residential. CMHC rules allow commercial mortgages to have amortization beyond 25 years, but they would have to pay a surcharge if their amortization is longer than 25 years.
Examples of Interest Only Mortgage
Meridian Credit Union offers what it calls a Hybrid Mortgage. Meridian Hybrid Mortgage consists of a conventional mortgage for a minimum of 20% and an interest only mortgage for a maximum of 60%. In total, Meridian Hybrid Mortgage can fund as much as 80% of the purchase price home value, whichever is lower. You are advised to transition your interest only portion of the mortgage into the conventional portion over time.
Merix Financial also offers interest only mortgages for up to 80% of a real property's value.