An All-Around Guide on the Mortgage Stress Test in Canada

A frequent desire for many Canadians is to purchase a first home after completing their education and finding work. After all, owning a home is the Canadian ideal. 

While it is commonly known that saving for a down payment is the first step toward buying a home, many people are unaware of the mortgage stress test. That raises the question, what exactly is the Canadian mortgage stress test?

Stick around, and let’s find out!

What Is the Mortgage Stress Test?

Several elements might influence the cost of buying a property, the most obvious of which is the interest rate. While other factors might cause the price of a property to rise, the mortgage rate is the most important, especially if you are financing a home with a variable rate mortgage. Variable mortgage rates are linked to the Bank of Canada rates and rise or fall in response to the bank’s direction. 

Through the Minister of Finance and the Office of the Superintendent of Financial Institutions (OSFI), the Canadian government reduces mortgage default risk and other housing-related concerns by establishing a qualifying benchmark rate known as the stress test on a mortgage

OSFI sets the mortgage stress test rate for uninsured mortgages, while the Minister of Finance sets it for insured mortgages. Financial institutions not regulated by the federal government are not required to utilize the mortgage qualifying rate, but they are free to do so. 

Previously, the mortgage stress test rate was 4.79%. However, starting in June, it is now applicable to all insured and uninsured mortgages (homes purchased with down payments of less than 20%). 

The mortgage stress test rate is greater than the actual lending rate offered by the bank. It is so to ensure that you can afford any future increases in your mortgage payments. The OSFI set new mortgage stress test rates for uninsured mortgages on June 1 that are the higher: 

  • 5.25%.
  • A rate equal to the agreed-upon contractual mortgage plus 2%. 

OSFI will review this rate every year. 

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How Does the Mortgage Stress Test Work?

We believe that the stress test makes it more challenging to qualify for a mortgage and diminishes the typical Canadian’s capacity to finance a home. Here’s why:

If you apply for a $500,000 mortgage loan with a 5-year fixed rate of 2.5% and a 25-year amortization period, the financial institution will determine your affordability based on the higher of:

  • 4.5% (2.5% plus 2%)
  • 5.25% (qualifying rate)

Even while this would not be the rate you had to pay on your mortgage, the rate utilized to evaluate how much loan you could afford for a house purchase would be 5.25% in this example. 

This automatically raises the mortgage cost you should be able to afford predicated on your income and work status while lowering the amount of house loan you can get (which will be less than the $500,000 you originally planned to borrow).

You can calculate this with a mortgage stress test calculator.

Who Does the Mortgage Stress Test Apply to?

Both insured and uninsured new mortgage applicants must pass the mortgage stress test. The mortgage stress test would also apply if you already have a mortgage and wish to refinance it, switch lenders, or take out a home equity loan

What is the Purpose of the Stress Test?

Initially, the goal of the mortgage stress test was to prevent potential homeowners from taking out a loan that was too expensive for them, putting them in even more debt and contributing to Canada’s household debt crisis. Canadians owe $1.70 after taxes for every dollar they make since the average household is in debt up to 170% of their disposable income. 

In July 2016, OSFI suggested modifications to housing and mortgage rules in Canada, as this was becoming an issue. One of the proposed reforms was to require future homebuyers who borrow from banks or other federally regulated lenders to take a mandatory mortgage stress test. 

Initially, the mortgage stress test only applied to those seeking a high-ratio mortgage, i.e., those making up to 20% down payments and had to pay mortgage default insurance premiums. However, as of October 17, 2017, all potential homeowners, even those seeking standard uninsured mortgages, must take the mortgage stress test (i.e., paying a down payment higher than 20%).

Mortgage Stress Test Rules in Canada

Here are the essentials that you need to know about the new mortgage rules, whether you’re purchasing a home or refinancing:

  • Mortgage qualification criteria (stress test): All mortgage borrowers must pass qualifying criteria (known as a stress test) to see if they can afford their principal and interest payments if interest rates rise.
  • Default Insured Mortgages: For house buyers with less than a 20% down payment, the stress test would utilize the insured minimum qualifying rate or the customer’s mortgage interest rate + 2%, whichever is higher. 
  • Conventional Mortgages: Mortgages with a 20% down payment or higher are subject to a stress test based on the minimum qualifying rate set by the OSFI or the customer’s mortgage interest rate plus 2%, whichever is higher.
  • If you’re renewing your TD Mortgage, these rules don’t apply: New mortgage loan agreements are the only ones affected by the new regulations.

Impact of the Mortgage Stress Test on Canadians

The harsher stress test will decrease borrowers’ theoretical buying power by about 4%. This will primarily affect people who already have significant debt-to-income ratios. It will also have a similar effect on buyers, whose borrowing ability will decrease by around 5%. 

Mortgage Stress Test Example

A household with an annual income of $100,000 could qualify for a property worth $651,000 with a 20% down payment and a five-year fixed mortgage rate of 1.78% amortized over 30 years under the prior 4.79% qualifying rate. That family’s maximum affordability would drop to $618,000 under the new stress test rate of 5.25%. 

How to Prepare for the Canada Mortgage Stress Test?

Although you won’t be able to change your lender’s rate on your stress test rate, knowing where you stand before you apply can help. You should discuss it with a mortgage broker or a real estate agent to get an expert’s opinion.

Here are a few critical metrics to consider when determining how much stress a borrower can withstand for better planning. 

Gross Debt Service Ratio

GDS is the proportion of pre-tax income required to cover total housing bills. In addition to the stress-tested monthly mortgage payment, The lender considers all monthly expenses, including condo fees, property taxes, and utility bills. Then he divides the total costs by the gross monthly revenue. However, the percentage should not exceed 32%.

Total Debt Service Ratio

The mortgage stress test includes the loans you already owe. As a result, lenders consider your overall debt. TDS is the percentage of your monthly income required to pay down your debts. Car payments, personal loans, school loans, credit cards, lines of credit, and other debts are examples of this type of debt. After adding all of your debts together, the ratio should not exceed 42% of your gross monthly income. Your mortgage will not be approved if it exceeds 42%. However, if this is the case, follow the steps below to correct this. 

Pay Down Your Debt

As previously stated, the most significant aspect in assessing your eligibility is your debt. If you have a lot of debt, your TDS will be high, and your chances of getting approved will be slim. However, if you pay off your present debt, your TDS will be low, and you will be accepted almost immediately. When paying off debt, prioritize high-interest debt such as credit cards. 

Apply for a Smaller Loan Amount

Be honest with yourself about how much money you can afford to spend on a home. When you can only afford a $500,000 house, it’s not a good idea to go for a $900,000 house. Taking a smaller loan will help you pass the test easier, and it will free up more of your income.

Crunch Some Numbers 

The first question you should ask yourself is if you can afford to pay an extra $500 if mortgage rates rise. This is an important question, especially if you’re looking for a variable mortgage. So, if you need to pay an extra $500 every month, would you be willing to do so? Or will it lead to a financial downturn?

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Can you Avoid the Mortgage Stress Test?

Big, established banks provide federally regulated mortgages that may be subject to stress testing. However, many alternative lenders offer mortgages without having to put their customers through the mortgage stress test

In this instance, you might want to look into one of these alternative lenders so you don’t have to go through the stress test required by a traditional bank. 

A growing number of lenders, including prime lenders, are offering mortgage products that bypass the mortgage stress test, such as:

  • Mortgage Finance Companies (MFCs)
  • Private Lenders
  • Mortgage Investment Corporations
  • Credit Unions

Private lenders may give you approval faster, as their loan rules are less stringent. However, if you have a less-than-stellar financial history, you may be liable to higher interest rates in exchange for faster mortgage approval. 

If you’re worried that your job status, debt load, or credit score may cause you to fail the stress test on your mortgage, you can avoid it by applying for a house loan with a lender that doesn’t require it. 

Conclusion 

One of the ways lenders determine how much home you can buy is through a mortgage stress test. The stress guarantees that home purchasers can cover their mortgage costs even if interest rates rise or other unfavourable future events occur, such as an economic downturn or job loss. 

While the stress test is helpful in preventing house repayment problems and possible mortgage default, it decreases the amount of housing loan you may get authorized for from a lender.

When you want to buy a house or refinance your mortgage, you should talk to a mortgage specialist or financial counsellor who can give you essential information about the process and help you determine your affordability.

FAQ

How to avoid the mortgage stress test?

The easiest way to avoid the mortgage stress test is through private lenders because their loan rules are not as strict, and they offer tons of mortgage products designed to bypass the test.

How do you pass a mortgage stress test?

You have to be able to afford your mortgage payments if your interest rate rises to the qualifying rate to pass the mortgage stress test.

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