For many Canadians, buying a home is a significant financial goal. When you purchase a home, this usually involves huge financial commitments, and thus, you need to be capable of bearing all the associated costs that come with a mortgage. For this reason, the Canadian government has taken steps to ensure that homebuyers can afford current and future mortgage payments by introducing the mortgage stress test. To understand the mortgage stress test, it is important to have a clear picture of how the mortgage process works.
How The Mortgage Process Works
Financial institutions provide loans for purchasing a house; such loans are referred to as mortgages. You can get a mortgage from banks, credit unions, insurance companies, trusts or mortgage companies. The borrowing conditions and requirements vary across different financial institutions, and hence, you can compare mortgage offers to find a lender that provides the best options for you. Some financial institutions also work with mortgage brokers to provide mortgage opportunities. Mortgage brokers have access to different lenders and thus can provide different options to choose from.
Whether you choose to explore mortgage options individually or through a broker, you would need to get pre-approved for a house loan. During the pre-approval process, the financial institution assesses your ability to finance a home and also determines what amount you would be able to borrow toward your home. The mortgage pre-approval amount depends largely on prevailing interest rates and your job status, income level, financial assets, financial liabilities and credit score –– how well you manage and pay your debt.
To provide you with a mortgage pre-approval, lenders carry out calculations and tests to determine how much housing debt you would be able to afford. One of such tests is the mortgage stress test.
What Is A Mortgage Stress Test?
There are quite a few factors that can impact the cost of purchasing a home; the most apparent one to the average Canadian is the interest rate. While other underlying elements can cause the cost of a house to increase, the mortgage rate takes the forefront especially if you finance a home purchase with a variable rate mortgage. Variable mortgage rates are pegged to the Bank of Canada rates and increase or decrease based on the direction of the bank rates.
Because of the fluctuation in interest rates, the Canadian government through the Minister of Finance and the Office of the Superintendent of Financial Institutions (OSFI) aims to mitigate mortgage default risk and any other risks linked to the housing market by setting a qualifying benchmark rate called the stress test. OSFI is responsible for setting the mortgage stress test rate for uninsured mortgages; for insured mortgages, this is set by the Minister of Finance. Financial institutions not regulated by the federal government are not mandated to use the qualifying mortgage stress test rate but can apply this test voluntarily.
The mortgage stress test rate was previously set at 4.79%; however, in June, this rate was revised and is now applicable to all mortgages inclusive of both insured mortgages — homes purchased with down payments of less than 20% — and uninsured mortgages.
The mortgage stress test rate is higher than the actual lending rate you would receive from the financial institution. This is done to ensure you can afford any possible increase in mortgage costs. Effective June 1, the new mortgage stress rates set by the OSFI for uninsured mortgages are the higher of:
• The agreed-upon contractual mortgage rate plus 2%.
This rate is expected to be reviewed annually.
How The Mortgage Stress Test Works
I believe the stress test makes it more difficult to qualify for a mortgage and reduces home purchase affordability for the average Canadian. This is why:
If you want to apply for a mortgage loan of $500,000 at a 5-year fixed rate of 2.5% and an amortization period of 25 years, the financial institution would assess your affordability on the higher of:
• 4.5% (2.5% plus 2%).
• 5.25% (qualifying rate).
In this case, the rate used to determine how much loan you could afford for a home purchase would be 5.25% even though this would not be the rate you have to pay on your mortgage. This automatically increases the amount of mortgage cost you should be able to afford based on your income and employment status and reduces the amount of house loan you can access (which would be less than the $500,000 you originally intended to borrow).
On the other hand, if you were approved for a mortgage rate of 3.5%, the applicable rate for a stress test would be 5.5% as this is higher than 5.25%.
Who Does The Mortgage Stress Test Apply To?
The mortgage stress test applies to both insured and uninsured new mortgage applicants. If you already have a mortgage and want to refinance a new mortgage, change your mortgage lender or take out a home equity loan, the mortgage stress test would also apply to you.
Key Takeaway About The Stress Test
A mortgage stress test is one of the ways lenders test how much home you can afford. The stress test aims to ensure that homebuyers can offset their mortgage expenses even in the event of an increase in interest rates or other negative future events, such as an economic downturn or loss of employment. While the stress test is beneficial for mitigating house repayment difficulties and possible mortgage default risk, it reduces the housing loan amount you can get approved for by a financial institution.
When you intend to purchase a home or refinance a mortgage, it is recommended to speak with a mortgage professional or financial advisor to provide key information on your mortgage application process and help assess your affordability.
How about mortgages without a stress test?
In fact, there are private lenders that do not require a stress test. If you are interested to know more, reach out for a free consultation and we'll review your options with you.
GreenFlow Financial's CEO, Reza Ghazi, is an official member of the Forbes Finance Council. He has provided the article below for Forbes which has been published on their website as well.