For most people, buying a home is a big purchase—and not one they make more than a few times in their lives. This makes sense. After all, real estate can be quite expensive. No wonder mortgages are one of the most popular types of loans. A mortgage allows people to buy their dream homes, even if they can't afford to purchase it outright.
However, since 2018, anyone applying for a mortgage from a federally regulated lender is now obliged to take the OSFI Mortgage Stress Test. What is a mortgage stress test? How will it affect your home-buying process? Can you avoid a mortgage stress test? Let’s find out!
What is a Mortgage Stress Test?
In financial terms, a stress test involves checking if payments can be made even in worst-case scenarios. These include anything that may affect your ability to pay back debt such as losing your job, an accident, or even illness. So, what is a mortgage stress test? It is a test that allows federally regulated lenders to check if you can still make your mortgage payments at a higher rate of interest, than the one you would actually pay. This is important for a few reasons. First, mortgage interest rates keep fluctuating. Based on these interest rates, the cost for real estate also fluctuates. This means that average home prices also tend to increase. Taking a mortgage stress test helps you understand if you will be able to afford to pay your mortgage even if interest rates shoot up. It could also affect your decision on the home or real estate you eventually buy.
What is the Canadian Mortgage Stress Test?
Since 2018, all Canadian homebuyers are subject to the Canadian Mortgage Stress Test. This test is applicable to all mortgages. Every federally regulated lender needs to conduct a Mortgage Stress Test to check if the homebuyer can pay their mortgage if the interest rate fluctuates. Of course, when you take out a mortgage, you will get the lowest possible interest rate when you apply. To be on the safe side, however, your lender is still obligated to check if you will be able to pay the mortgage even if the interest fluctuates and is above your contracted rate.
The lender will check if you are capable of making your mortgage payments based on the Bank of Canada qualifying rate. How do they calculate the qualifying rate for the mortgage stress test? The qualifying rate is based on the mode average of posted 5-year fixed rates from the bigger Canadian banks. The minimum qualifying rate is based on either the Bank of Canada qualifying rate of 5.25% or the rate offered by the lender, plus 2%.
Changes to the Canadian Mortgage Stress Test
Up until June 2021, the qualifying rate was 4.79%. The Bank of Canada has now raised its qualifying rate to 5.25%. What does this 0.46% increase mean for homebuyers? Well, the higher the qualifying rate, the more difficult it gets to pass the mortgage stress test. Remember, the stress test is designed to check if you can still make your mortgage payments in the worst-case scenario. A higher rate means the chances of not being able to make your payments at that rate is also higher. This also means that homebuyers have reduced purchasing power. However, there’s no reason to worry about your mortgage stress test. With enough preparation and understanding exactly how a mortgage stress test works, we’re going to help you take all the ‘stress’ out of your mortgage stress test!
Understanding the Mortgage Stress Test
Let’s look at an example to help you understand the mortgage stress test better. Suppose you were looking to buy a home in Saskatoon. Your household income is $200,000, you will be making a down payment of $50,000, and you have qualified for a mortgage rate of 2.5%.
With a 5-year term, amortized over 25 years, you would qualify for a home valued up to $750,000 under the current 5.25% qualifying rate.
Now let’s look at some of the factors that would determine if you passed the mortgage stress test.
Down payment
The higher your down payment, the higher the mortgage you can afford. So, if instead of $50,000, you find that you can pay $150,000 as the down payment, then it signals that you can afford to take out a larger mortgage. However, for the sake of the example, we will consider the down payment to be $50,000.
Interest rate
Your mortgage interest rate is one of the key factors that will help you to check if you would pass the mortgage stress. Usually, if your mortgage is pre-approved, you would be able to know your exact interest rate. In our example, you have qualified for an interest rate of 2.5%, so we’ll use that figure.
Increased rate of interest
Once you know your mortgage interest rate (or an estimated interest rate), you need to check if you would still be able to make your mortgage payments if your interest rate were increased to the 5.25% qualifying rate or by 2%. In our example, a 2% increase would mean your interest rate would be 4.5%. As you know, to stress test your mortgage, you must check against the qualifying rate (5.25%) and a 2% increase to your mortgage provider’s rate. Don’t worry about the actual calculation. You can use our easy mortgage calculator to calculate your monthly payments at the qualifying rate (5.25%) and if it were to increase by 2% (that’s 4.5%).
Monthly payments
After you find the exact amount of your monthly payments using our online mortgage calculator, you can easily check whether you can afford to make your mortgage payments at the qualifying rate. Continuing with the example, if your interest rate were 2.5%, your monthly mortgage payments would come up to $4,432. Checking against a 2% increase, your monthly mortgage payments would come to about $4,975. If we were to check against the qualifying rate of 5.25%, your monthly mortgage payments would also come up to $4,975. Would you be able to afford the additional $543, considering all your other expenses and debt? If you can, you’ve passed your mortgage stress test! It’s that simple.
Still have some questions? You can always reach out to one of our mortgage specialists who would be happy to help you. If you have understood all about mortgage stress tests, let’s get into how you can prepare for a mortgage stress test.
Preparing yourself for your Mortgage Stress Test
The first step? Before even thinking about a mortgage stress test, talk to an experienced mortgage specialist to know about your mortgage options. There are many factors that determine your eligibility for mortgage loans and mortgage interest rates. As you’ve seen above, the terms of your mortgage stress test will depend on the terms of your mortgage. So, it’s crucial to get your hands on that information first. Here are some important factors that determine your eligibility for a mortgage.
Debt
The debt you carry right now is a deciding factor when it comes to your eligibility for a mortgage. Make sure to pay down your debt so that your debt amount is considerably lower before applying for a mortgage. The lower your debt, the higher the chances of passing your mortgage stress test.
Total Debt Service Ratio (TDS)
Lenders use a Total Debt Service Ratio or TDS to check the proportion of gross income that is already spent on debt and other payments. These payments include credit card payments, loans like personal loans and student loans, car payments, etc. Your TDS should not be more than 40% of your gross monthly income.
Gross Debt Service Ratio (GDS)
Lenders use a Gross Debt Service Ratio or GDS to check the proportion of housing debt that a buyer is paying in comparison to their income. These include utility bills, property tax, etc. Your GDS should not be more than 32% of your gross monthly income.
When you are crunching your numbers, make sure to check if adding a certain amount to your monthly payments would be financially feasible for you. As we’ve said above, that is exactly what the mortgage stress test checks - if you will be able to pay a higher monthly payment if the interest rate increases.
Apart from checking your debt, TDS, and GDS, there’s another important thing that you should be checking. That’s Canadian mortgage regulations. The qualifying rate will be annually reviewed by OSFI, so you should check every year at least. The revised 2021 qualifying rate of 5.25% has come under scrutiny. However, the mortgage stress test won’t be going away any time soon. Of course, you can always contact a mortgage specialist who would be able to inform you about any regulations and help you find the best mortgage interest rates to help you buy your dream home.
We hope you’ve now got a firm grasp on what a mortgage stress test is all about — and the next time you think about a mortgage stress test, you won’t feel any stress.