With 60% of Canadian mortgages set to renew over the next three years, homeowners face a "payment shock" unless interest rates drop significantly, according to the Royal Bank of Canada.

Darko Mihiclich, an RBC Capital Markets analyst, said in a Monday report, "By 2026, when $400 billion (C$290 billion) worth of mortgages are to be renewed — a figure that includes a significant share of so-called negative amortization loans — the increase in monthly payments could reach 48% on a weighted average basis."

He wrote, "We believe a large number of mortgages will come due in the next three years" and "this payment shock (the increase in payment at renewal) could be substantial and pose a significant risk to Canadian banks," "unless there are large drops in interest rates, we believe credit losses will inevitably increase, possibly significantly in 2025 and beyond."

Mihiclich expects smaller — but still significant — payment shocks of 32% next year, when more than C$186 billion of mortgages are scheduled for renewal, and 33% in 2025, when around C$315 billion in housing loans are renewed.

If the Bank of Canada overnight rate, currently 5%, were to drop by 100 basis points, it would reduce the payment shock in 2024 and 2025 to about 22% or 23%, according to the report.

But the renewal cohort in 2026 is likely to face the biggest challenges. That is when a large portion of adjustable-rate mortgages with fixed monthly payments will be renewed. These borrowers continued to make the same monthly payments as interest rates rose, but in many cases now only pay interest each month, which increases the time it will take them to repay the loans — also known as negative amortization. Upon renewal, they will face much higher monthly payments.

Mihiclich wrote: "Adjustable-rate mortgages are expected to experience a significant payment shock, possibly up to 84% by 2026 if interest rates do not decline," "and interest rates will need to fall significantly to 'rescue' this group."

To reduce the payment shock to 20% for the entire variable interest rate group, for example, the Bank of Canada would need to cut the overnight rate to 0.25% by July 2026, which Mihiclich said is "probably an unreasonable expectation at this time."

Beyond the pain faced by borrowers, the dynamics create a challenging environment for local retailers in major Canadian banks, and RBC Capital Markets maintains its "lukewarm" revenue growth outlook of about 4% in 2024 and about 3% in 2025 for personal banking in the country.

Mihiclich said, "We believe the mortgage payment shock is likely to affect loan/revenue growth, mortgage delinquency (albeit modest) and losses in other forms of credit," but "Canadian banks are not standing still and are proactively moving to limit the payment shock for their customers, which could have a significant impact."

He said lenders are working with customers to encourage them to increase their monthly payments now, make lump sum payments, extend their loan terms, or switch from variable-rate mortgages to fixed-rate loans.