In late 2017, the federal government introduced a Mortgage Stress Test for anyone applying for or renewing a home loan.
Even if you have amazing credit and a 20% down payment, you still must go through the stress test.
Starting June 1, Canadian homebuyers will face tougher mortgage stress test rules that will decrease the buying power of most borrowers.
Here’s what you should know before you apply for your next home loan:
What is the mortgage stress test?
First off, it’s not really a test. Rather, it’s a more stringent set of rules banks must now use to determine if you qualify for a mortgage and, if so, how much you can borrow.
Why was the mortgage stress test created?
The new mortgage rules exist to protect borrowers, like you. Because interest rates have been at historic lows that can (and will) only go up, the government wants to make sure you’ll still be able to afford your mortgage payments when rates eventually do rise. Otherwise, if you can’t afford higher payments in the future, you might be forced to default on your mortgage and lose your home.
How does the mortgage stress test work?
When you apply for a mortgage, the bank will offer you an interest rate based on your credit score. Under the stress test, however, that is not the rate the lender will use to determine your mortgage eligibility. Rather, it will make those calculations at a considerably higher interest rate, to ensure you’ll be able to make your payments if/when rates go up, as explained above.
So, what interest rate will your lender use? As of June 1, the minimum qualifying rate for both uninsured (with at least 20% down payment) and insured (less than a 20% down payment) mortgages will be the higher of the following:
- The rate offered by your lender plus 2%; or
- 5.25% (up from 4.79% prior to June 1)
To put this into real terms, if you wanted to borrow $400,000 and your lender is offering you a rate of 1.78%, you would have to prove you can afford a mortgage payment of about $2,385 per month (at 5.25%), even though your actual monthly mortgage payment (at 1.78%) would be considerably lower: about $1,650.
In contrast, borrowers who got a $400,000 mortgage before June 1 had to prove they could afford a monthly payment of about $2,280 (at 4.79%), or about $100 less per month than under the revised rules. (If you got a mortgage pre-approved prior to June 1, your lender is allowed to stick to the old stress test guidelines, if it so chooses.) Obviously, the more that you are borrowing, the greater that difference will be.
How does the bank determine what I can afford?
There are two main figures banks use in this calculation “First is GDS [gross debt service ratio], which is the percentage of the borrower’s pre-tax income that will cover housing costs [including mortgage, heat and property taxes] and it should be no more than 32%,”. “Then there’s TDS [total debt service ratio], which is any outstanding personal debt [including mortgage, car loans, credit card debt, lines of credit, etc.] and should be no more than 40% of pre-tax income.”
Going back to our $400,000 mortgage example above, if we assume heating and property taxes brought your total monthly housing costs to $3,000, you’d need a pre-tax monthly income of at least $9,375 (or $112,500 annually) to have a GDS of 32% or less. Similarly, based on that income, your total debt load could not exceed $3,750 per month (including your mortgage payment) to have a TDS of 40% or less in this scenario.
What does the stress test mean for borrowers?
If you are a first-time potential homeowner trying to get a foot into the market, the stress test makes it a lot harder for you. For example, if there were no stress test at all, our hypothetical household with an annual income of $112,500 (and debt levels within the 40% TDS threshold) could qualify for a mortgage of $577,500, assuming a five-year fixed rate of 1.78% and 25-year amortization. Using the pre-June 1 stress test rules, the same household could borrow only $418,500, and now under the new stress test rate of 5.25%, the maximum mortgage decreases to $400,000. “That’s a huge difference when you’re a first-time home buyer,” she says. “Especially with the hot real estate market, limited supply, and increases in prices.”
Renewing mortgage holders only need to “pass” the stress test if they switch lenders. “But they can’t really shop around for a better rate or negotiate with their existing lender when they renew, so it affects them as well,” she says.
Is there any way to side-step the stress test?
Not really. Canada’s big banks are mandated to enforce these rules while other lenders, such as credit unions, use them voluntarily to reduce their risk exposure. Plus, the Office of the Superintendent of Financial Institutions (OSFI), which sets the minimum qualifying rate for uninsured mortgages, has announced it plans to review the guidelines each December to see if any adjustments are necessary. That means the stress test could become even more stringent in the future.
