We prepare for the worst every day: We carry umbrellas when it’s cloudy, pop a Gravol(or two) before a long flight, and buy travel insurance when going overseas. Why should taking on a mortgage be any different? A mortgage stress test is one way of preparing for the worst… it’s also a legal requirement in Canada.
As of yesterday, it’ll be a bit tougher for new and renewing mortgage borrowers to qualify for their home loan. A higher threshold for the “stress test” has come into effect, requiring borrowers to prove they can carry their mortgage costs at an interest rate of 5.25% or their contract rate plus 2%, whichever is higher. This is a slight increase from the previous threshold of 4.79%. The stricter criteria applies to both insured mortgage borrowers (those who make a down payment smaller than 20% on their home purchase) and uninsured borrowers, who put down 20% or more.
What Does the Stress Test Do?
Simply put, in order to pass the stress test, borrowers must have healthy-enough incomes and debt servicing ratios to indicate they could pay their mortgage payments at the higher interest rate, regardless of the rate they actually get from their lender. For context, current fixed and variable mortgage rates are as low as 1.7% – 2% for a five-year term, so the stress test will tack on at a minimum 3% or higher. This translates to borrowers qualifying for a smaller mortgage amount.
How Will the Stress Test Impact Home Buyers?
However, as borrowers have been stress tested since 2018, the impact of this latest change will be fairly minimal. A buyer looking to purchase the average-priced home in their city would face a dip in affordability of about 3.8%, with between $14,000 – $47,000 shaved off the amount they’d qualify for. To make up for this difference, the study determined borrowers would need to supplement their incomes between $2,000 – $9,000 in order to qualify for the same size mortgage under the new stress test, depending on the city they’re purchasing in.
We calculated the income required to qualify for a mortgage large enough to purchase the average-priced home in 11 cities across Canada at both a mortgage rate of 4.79%, and then at 5.25%. It was assumed home buyers had no additional debt, were making a 20% down payment, and were amortizing their mortgage over 30 years.
Check out the infographic below to see how the stress test impacts average home buyers across Canada:
Why Is the Stress Test Being Increased?
The tougher stress test is part of efforts by both the federal banking regulator (OSFI) and Department of Finance to reduce the amount of risky mortgage debt currently held by Canadians as a result of the pandemic home buying boom. Part of the issue is the aforementioned historically low mortgage rates; interest rates have been kept at record lows over the past year by the Bank of Canada to protect the economy and keep liquidity in the market. However that’s made it cheaper to get a mortgage than ever before; combined with lockdown buyer psychology and pent-up savings, buyers have been motivated to get into the housing market at an unprecedented rate.
That has pushed home prices to stratospheric new heights in markets across Canada, as buyers working and schooling from home have sought properties with more space. The ability to work from home has also decoupled them from big city centres and shifted demand to smaller suburban and rural markets, known for their comparable affordability. However, supply has struggled to keep up with demand. Bidding wars and homes selling for far over their listing price has become the norm, even in secondary markets where these dynamics were previously rare.
As a result, more home buyers have had to bid higher than they otherwise would have to win their homes, and have taken on larger mortgages. The concern is that when interest rates do inevitably rise, these newly-minted homeowners will struggle to keep up with their mortgage debt
The Bottom Line
It’s important to keep up to date on changes to Canadian mortgage regulations, as they can directly impact your mortgage. Beyond that, the best thing you can do to increase the amount you can borrow is to earn more money and save more for a down payment.
It also doesn’t hurt to ask a mortgage broker for help when stress testing a mortgage before you buy. In addition to helping you find out what your ideal debt service ratios and maximum interest rate are, they can keep you up to date on changes to lending policies that can affect how much you can borrow.
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