Starting in 2018, all Canadian buyers who are applying for a mortgage from a federally-regulated lender are now required to undergo the OSFI Mortgage Stress Test, including those who put at least 20% as a down payment. This certainly affects homebuyer hopes, as their finances are even more closely scrutinized before gaining mortgage approval. Basically, borrowers are required to prove their ability to make mortgage payments, even in times when interest rates go up. So, how will Canadians deal with the mortgage stress test in 2021 and beyond? And how will this stress test continue to be a part of the home buying process? Let’s look at the new mortgage rules in greater detail and how it impacts home buyers in 2021.
Canadian Mortgage Stress Test Explained
From a financial perspective, a stress test is just how it sounds. It’s a way of testing how you and your finances might be affected by a sudden bout of financial turmoil, such as a loss of employment. When it comes to mortgages, it’s how you, as the potential homeowner, would cope with your mortgage payments in the event that your interest rate rises or you suffer a financial emergency of similar circumstances. Simply put, the stress test forces you to come face-to-face with the very high costs of being a homeowner. So, all potential homeowners will now need to prove they can afford their potential mortgages based on their lender’s minimum “qualifying rate”. In order to pass the mortgage stress test, you’ll need to qualify at your contracted mortgage interest rate plus 2% or 5.25%, which is the benchmark rate (or floor) used to qualify uninsured mortgages. For example, if you are applying for a mortgage at a rate of 3.65%, then your lender will assess you as if you were paying your home loan at 5.65% (3.65% + 2%) since 5.65% is greater than the benchmark rate. Because of this stress test, the majority of new homebuyers have had their purchasing power slashed by as much as 20% because they’re only eligible for a lower loan amount at the mortgage stress-tested rates. The new stress test rules have also made it more difficult for current homeowners to refinance or renew their mortgages.What is the Purpose of the Stress Test?
Basically, the stress test was designed to tackle the household debt issue in Canada and prevent consumers from getting themselves into even more debt by taking on a mortgage that’s too big for them. In fact, the average household in Canada is indebted at 170% of their disposable income, which means that Canadians owe $1.70 for every dollar they earn after taxes. With the gradual rise of housing and interest rates across the country, many would-be homeowners wouldn’t be able to afford their houses in the years to come. In an effort to alleviate the country’s household debt problem, the Office of the Superintendent of Financial Institutions Canada (OSFI) proposed some changes to Canadian mortgage and housing rules in July of 2016. One of which is the implementation of a new mandatory “stress test” for potential homeowners who are borrowing through federally regulated lenders, such as banks.
Originally, the test only applied to people applying for high-ratio mortgage, meaning those who weren’t making more than a 20% down payment, and therefore subject to mortgage default insurance premiums. The test also included homeowners with a mortgage term of fewer than 5 years. However, as of October 17th of 2017, all candidates, even those applying for conventional uninsured mortgages (more than a 20% down payment), will have to take the test.
This new regulation, which applies to both new applicants and current borrowers planning on switching lenders when their mortgage term ends, is due to take effect on January 1st, 2018.How to Prepare For the Mortgage Stress Test There’s not much that can be done about the benchmark rate and the rate that your lender is charging you, but it would help to have a basic understanding of where you stand before you apply for a mortgage. Ideally, you should chat with a mortgage broker or real estate agent.
Lenders use a few key metrics when assessing borrowers to make sure they’d be able to pass the stress test and manage mortgage payments, including the gross debt service ratio (GDS) and total debt service ratio (TDS).
Gross debt service ratio (GDS) – Your GDS represents the percentage of your pre-tax income that’s required to pay all housing costs. Your lender will not only look at your stress-tested monthly mortgage payment, but the cost of all other monthly expenses, including condo fees (if applicable), utility bills, and property taxes. All of these costs will be added together and divided by your gross monthly income. Ideally, lenders want to see a percentage of no more than 32%.
Total debt service ratio (TDS) – All your debts will need to be factored into the equation as well, which is why lenders will also look at your TDS. This represents how much of your monthly income is needed to adequately cover your debts. That includes car payments, personal loans, student loans, credit cards, lines of credit, and so forth. When all of these are added up, your TDS should be no more than 42% of your gross monthly pay in order to get approved. To better prepare yourself for the stress test, consider taking the following actions:
Pay down your debt. As already mentioned, your lender will look at all the debt that you currently carry and factor it into their assessment of whether or not you’d be eligible for a mortgage. The smaller your current debt load, the lower your TDS will be. In turn, your stress test results may be more favourable. Focus on paying down your high interest debt first (such as your credit cards) to avoid paying so much in interest charges.
Apply for a smaller loan amount. Be realistic about how much house you can actually afford. You might have your sights set on a home in the $800,000 price range, but perhaps you might make things a lot more financially feasible for yourself if you look at homes in the $600,000 range instead. Not only will this increase your odds of passing the stress test and getting approved for a mortgage, but it can also free up more of your income.
Crunch some numbers.
Ask yourself if you could really afford to pay an additional $500, for example, in mortgage payments if rates suddenly increase after you’ve been approved. This is especially true for those with a variable rate mortgage. Being that variable rates are determined based on the prime rage, if you have one, your mortgage is going to be immediately impacted by a rise in general interest rates. So you might be comfortable making $1,000 mortgage payments every month, but what if you were required to throw in an additional $500? Would that be doable? Or would that throw you into a financial frenzy? That’s exactly why this stress test was implemented.
Should you be faced with higher rates in the near future, your lender would want to make sure you’d still be able to make your payments in full every month rather than face defaulting.
Can I avoid The Stress Test? The stress test is designed for federally-regulated banks. But some mortgage lenders, such as credit unions and private lenders, are not under OSFI’s jurisdiction. As such, lenders like these are not required to put their mortgage applicants through these stress tests the way traditional banks and other federally-regulated lenders must. So, if you’re one of those prospective homeowners, alternative subprime lending might be a viable option for you. However, it’s important to be aware that the interest rates most alternative lenders charge are higher than those of a traditional lender. In fact, with these new housing regulations, alternative lenders have come into a position where they’re able to charge even more for their services. So, while you might qualify easier with a non-traditional lender, it’s good to keep these issues in mind before you apply with one, as it could end up costing you more down the line.
The Future of The Stress Test
Many applicants have already felt the wrath of the stringent rules of the mortgage stress test and have had their purchasing power reduced. As a result, the mortgage stress test rules have come under great scrutiny over the last year, and as such, there is mounting pressure on the OSFI to ease the rules.While the intention of the rules was to ensure borrowers aren’t increasing their risk of defaulting and to slow down the housing market to ease skyrocketing prices, opponents suggest that the rules are simply too harsh.Since the introduction of the new stress test rules, markets have certainly cooled down in many markets and interest rates have started to rise. Such a situation has prompted the OSFI to review the rules surrounding the stress test.What does that mean for borrowers in 2021 and beyond? While the OSFI has not shown any intentions on changing the rules, only time will tell if that will change sometime soon going into 2021.
Many applicants have already felt the wrath of the stringent rules of the mortgage stress test and have had their purchasing power reduced. As a result, the mortgage stress test rules have come under great scrutiny over the last year, and as such, there is mounting pressure on the OSFI to ease the rules.While the intention of the rules was to ensure borrowers aren’t increasing their risk of defaulting and to slow down the housing market to ease skyrocketing prices, opponents suggest that the rules are simply too harsh.Since the introduction of the new stress test rules, markets have certainly cooled down in many markets and interest rates have started to rise. Such a situation has prompted the OSFI to review the rules surrounding the stress test.What does that mean for borrowers in 2021 and beyond? While the OSFI has not shown any intentions on changing the rules, only time will tell if that will change sometime soon going into 2021.
