Countless Canadians dream of someday owning their own home. They work hard, save their money, build up for a deposit, and eventually apply for a mortgage. But in recent years, the mortgage market has been transformed entirely by the introduction of the mortgage stress test. The stress test is designed to protect borrowers and mortgage applicants, ensuring that they'll be able to pay off their mortgages in the future, and this guide will introduce you to all you need to know about how it works and what it does.
The term 'stress test' can seem a little confusing to those who have little experience in the financial sector, but it's quite a common phrase among banks and other financial institutions. Basically, a stress test is a system of predicting a worst case scenario, and it can apply to a range of different financial situations. When it comes to mortgages, the stress test takes into account the fact that interest rates may rise by the time a borrower’s mortgage term comes up for renewal. It is in place to ensure that the borrower will be able to maintain their mortgage payment in the event that their rate increases significantly upon renewal to prevent future mortgage default, missed payments, or power of sale in the event that the payments become unmanageable.
Stress tests might seem unnecessary in the eyes of many, but they're actually very useful and are designed to protect everyday people wanting to make use of financial services like loans and mortgages. They help you figure out whether or not you're going to be able to afford to pay off the money you borrow, even if disaster strikes. Knowing in advance that you'll be able to pay off your loans or mortgages can be very helpful and reassuring, both for you and the bank or lender offering you the money in the first place. In short, stress tests can help to cut down on defaults, debts, and financial drama.
The Canadian mortgage stress test was officially introduced in 2017. Since then, every potential homebuyer looking for mortgage, regardless if it is an uninsured or high ratio mortgage, and homeowner looking to refinance their existing mortgage, has had to undergo the stress test if they want to get a mortgage from an A lender at AAA rates. Since interest rates have been so low in recent times and are destined to go up in the years to come, the mortgage stress test was introduced at a key moment to help Canadians see whether or not they'll be able to afford potentially higher mortgage payments in the future.
The stress test can be broken down as follows: whenever you apply for a mortgage through a bank, the bank will offer you an interest rate, which is mostly calculated based on your credit score and income to debt ratio. However, for the purposes of the stress test, the bank will then calculate your mortgage qualifying at a much higher rate, effectively generating a 'worst case scenario' for you as a borrower, and then testing to see whether or not you would be able to afford the payments at that high rate, even though your actual rate will be much lower.
The bank may use one of two possible rates: the five-year rate of the Bank of Canada or the rate generated by the bank, plus 2%. Whichever rate is higher will be the one used for the stress test. So, for example, if you're applying for a mortgage and the bank is offering you a rate of 1.79%, they'll either use the Bank of Canada 5-year rate, which as of the date that this article is written, is 4.79% in this scenario. Let's say the rate that you are offered is 3.19%, in that case the stress test rate would be 5.19%, calculated by adding 2% to your proposed rate of 3.19% for the purposes of the stress test, since the stress test is based on the greater of 4.79% or 2% added to your actual contract rate. However, some lenders, such as certain Credit Unions and Trust Companies are able to allow you to by-pass that stress-test rule and allow you to use the contract rate as your stress test rate. However, the rate for this is typically higher.
As of the date this article is published, the lowest non-stress test rate is 2.54% with DUCA Credit Union. So although it's higher than let's say a bank's rate of 1.59%, you will be able to qualify for a much higher mortgage amount with 2.54% as the qualifying rate instead of the stress test rate of 4.79% which will enable you to potentially get a mortgage rate as low as 1.59%. So it really depends on what you prefer between lower monthly payments or a higher mortgage amount.
Let's look at a specific example.
Maximum Mortgage Amount Qualified For: $523,869
Monthly Payment for a mortgage of $523,869 amortized over 25 years at 1.59% interest: $2,116.06 per month
Maximum Mortgage Amount Qualified For: $751,918
Monthly Mortgage Payment for $751,918 amortized over 25 years at 2.54% interest: $3,383.35 per month
As we can see, although the interest rate is higher by 0.95%, you would be able to qualify for a mortgage loan of $751,918 instead of only $523,869. That's an additional $228,049 in mortgage that you would be able to get in this example. It's important to note that the difference in monthly mortgage payment between an interest rate of 1.59% and 2.54%on a $751,918 mortgage amortized over 25 years is 346.13 per month. That's right! If you were to qualify for a $751,918 in mortgage amount at an interest rate of 1.59%, your monthly mortgage payment would be $3,037.22 per month instead of $3,383.35 per month at an interest rate of 2.54%.
So how does the bank actually figure out what you can afford and whether or not you'd be able to cope with the worst-case scenario outlined in the stress test?
Well, they make use of two key factors. The first of these factors is gross debt service ratio, or GDS, which is basically the percentage of your income that will go towards housing costs like heating bills, condo fees, property taxes, and mortgage repayments. The second factor is total debt service ratio, TDS, which is calculated by adding up your current debts from loans, credit cards, etc and added to your property taxes, heating costs, condo fees, and mortgage payments.
You need to have a GDS of 32% or less and a TDS of 40% or less in many cases in order to qualify with a bank. If you can meet these requirements, they will see that you should have enough disposable income, even taking debt and bills into account, to pay for your mortgage. Keep in mind that for your stress test qualifying rate, the banks will use the stress test qualifying interest rate which will be higher than the rate you will actually have to pay.
The stress test was made for a good reason and can help prevent people from getting into debt that they'll be unable to pay back, eventually finding themselves in very scary financial situations. However, there have been some negative side effects since the stress test was introduced. One of the biggest issues concerns first-time buyers who will now find it much harder to get approved for a mortgage to buy their first property.
Before the test was introduced, first-time buyers would have been able to qualify for larger mortgages and therefore had a wider range of potential properties to choose from. With the new rules, the maximum amount of your mortgage as a first-time buyer is reduced. With a volatile housing market across many parts of Canada, the stress test has clearly made it more difficult for many new buyers to break into the market.
Since its introduction, the mortgage stress test has been a legal requirement for schedule 1 banks, so there's not really any way to avoid it or get around it when applying for a mortgage at a bank. All major banks have to follow the rules and the vast majority of lenders do the same. So if you're applying for a mortgage, you'll probably have to go through the stress test, unless you work with a mortgage broker who has access to many lenders that are able to bypass the stress test and still provide you with great low interest rates in many cases. You can increase your chances of being successful in passing the stress test by saving up a larger down payment, reducing your debts, and finding a house within your means.
At Clover Mortgage, our mortgage broker experts can help borrowers in different financial situations qualify for the mortgage they need.
Get in touch with a Clover Mortgage broker today by email at email@example.com or call us at 416-674-6222 to speak with one of our friendly and helpful experts.