Fivewalls: The Mortgage Stress Test

As you prepare to purchase a home in Canada, you must be up to date with the new mortgage stress test rules. Continue reading to learn more about the recent changes to the mortgage stress test, how you can prepare for it, and possible ways to avoid it altogether. A mortgage stress test is ultimately a guideline designed to ensure you will financially be okay if interest rates ever rise and you are not overextending yourself.

Overview of Canada's Mortgage Stress Test

When you obtain a mortgage in Canada, you must undergo the CMHC mortgage stress test. This involves planning for a worst-case scenario before the initial home purchase is made.

A mortgage stress test allows buyers to make better choices and avoid costly mistakes by giving them an idea of how much they can afford and, most importantly, under what circumstances. For example, would you still be able to afford your mortgage if you lost your job or your income decreases? What about if interest rates increase unexpectedly or you have to refinance your home due to unforeseen circumstances?

In general, the higher the interest rate is, the less you will be able to borrow. This is because your monthly mortgage payments will increase along with rates!

The stress test will give you important feedback and answers to these types of questions so that you can make the right decision when it comes to purchasing a home.

How The Mortgage Stress Test Works

The stress test was previously for people putting a down payment of less than 20%, but now all homeowners will undergo the test.

If your payment is less than 20%, you will have to qualify for a mortgage with the minimum qualifying rate set by the Bank of Canada (currently 5.34% for five-year term), which is higher than you will actually be paying. Your income and other expenses (such as other loans) will be taken into consideration.  What you think you can buy versus what the bank thinks you can buy, can be a huge difference.

Before using the stress test, you may be approved for a mortgage of $500,000 with a five-year fixed-rate of 3.95%. Your monthly payments may be around $1,600+. But after using a qualifying rate of 5.34%, that will bump your payments up to $2,200+ and you may have to go with a different home.

If your down payment was more than 20%, the stress test will be calculated a bit differently. It will either be determined with the Bank of Canada’s current rate or your current mortgage rate + 2%. Whichever is higher will be used.  

Changes to The Mortgage Stress Test

In April 2020, the Bank of Canada announced changes to the way that qualifying rates are calculated regarding the mortgage stress test.

Traditionally, the qualifying rate was determined by using the average five-year fixed rate posted across major banks. The proposed changes would have altered this method to use the median five-year fixed rate instead and would have applied to all mortgages received by the CMHC that week.

This change would result in a mortgage stress test that used a rate that is almost 2% higher than the mortgage rate they would actually be receiving. Although this was already the case for uninsured mortgages, it would subject insured mortgages to the same parameters.

The proposed changes were delayed due to the COVID-19 pandemic, but the Department of Finance expects to move forward with them adjustments once the economy has recovered.

Bank of Canada's Qualifying Rate For The Mortgage Stress Test

The Bank of Canada's qualifying rate is based on the average of five-year fixed rates across major banks. Since the global COVID-19 pandemic has caused mortgage rates to drop significantly, they have tried to stimulate the economy by revising this rate.

Currently, the qualifying rate is 4.79%.

So, what exactly does that mean?

In simple terms, your income-to-debt ratio must meet the criteria assuming that interest rates were at 4.79%. Even if you qualify for a lower rate with a specific lender, you must be able to afford this higher rate to pass the stress test.

How Does The Mortgage Stress Test Affect Borrowers?

Since the stress test requires you to qualify for a mortgage at a rate of 4.79%, many buyers must take a smaller mortgage than they may otherwise be able to afford. This large hurdle can be especially difficult for first-time homebuyers, especially when they may have qualified under the previous regulations.

Even though you can shop around for different lenders to negotiate an actual interest rate, buyers are still required to pass the stress test regardless of which one they choose. For example, let's assume that you're can contract a rate with your lender at 3%. Although you have qualified for a lower rate, the mortgage stress test will still use the Bank of Canada's 4.79% and run affordability calculations for both scenarios.

If the buyer's annual gross income is $120,000 and their monthly living cost is $3,190, they would qualify for a $750,000 mortgage. This calculation assumes a 20% down payment and an interest rate of 3%.

When we use the stress test rate of 4.79%, though, they will only qualify for a mortgage of $625,000. Again, this assumes the same monthly cost of living and a 20% down payment. As you can see, the mortgage stress test can significantly reduce your purchasing power. Even though you may qualify for a 3% rate and could afford a $750,000 mortgage, you can only take out a loan value of $625,000 based on the stress test.

To get a better idea of what you may qualify for, try using a mortgage affordability calculator.

Important Metrics to Consider for The Mortgage Stress Test

There are two vital metrics that you should analyze before moving forward: the gross debt service ratio and the total debt service ratio.

Gross Debt Service Ratio

Your gross debt service ratio, often shortened to GDS, is the percentage of your pretax income that will be used to cover all of your housing expenses. Not only does the lender look at your stress-tested monthly mortgage cost, but they will also consider utility bills, property taxes, condo fees, and any other monthly expenses.

To calculate the ratio, add up all of these expenses and divided by your gross monthly income. Most lenders prefer to see this ratio at 32% or less. 

Total Debt Service Ratio

The total debt service ratio, or TDS, includes all of the debts you are responsible for. This calculation will determine what percentage of your monthly income is required to appropriately cover everything you owe.

Included in this calculation are things like personal loans, credit cards, auto loans, and other lines of credit. When you take all of these monthly payments into account, the total debt service ratio should not exceed 42% of your gross monthly income.

Does The Mortgage Stress Test Affect Re-Financing?

If you already have a fixed-rate mortgage term, you will not be affected by the new stress test rules. But when it comes time to re-finance with a different lender, you will face the same test with the Bank of Canada five-year fixed mortgage rate, not your current rate. Just because you were approved for a mortgage years ago does not mean you meet that criteria now, which could also make it harder to open a home equity line of credit.

Now that you understand some of the changes coming to the mortgage stress test - and how it works - let's review some ways that you can prepare for it. Unfortunately, there's not much that can be done about the qualifying rate or what rates are available from lenders. However, having an understanding of where you stand before you buy a home is ideal.

Preparing for Your Mortgage Stress Test

Here are a few ways that you can prepare yourself to pass the mortgage stress test:

Pay off your Debts

Since the mortgage broker is going to be looking at all of the debt you carry, not just the monthly cost of living, the lower your overall debt levels, the better. Smaller monthly payment requirements will also improve your total debt service ratio, and this may help you qualify for a higher mortgage.  Start with paying off the debts that carry a high-interest rate. Credit cards often have very high-interest rates, so start with those. Once you eliminate some of these balances, use the payments that were previously going towards interest to reduce your other outstanding debts.

Choose a Smaller Loan Amount

Although purchasing your dream home as a first-time buyer may seem like something exciting to work towards, it may be better to apply for a smaller loan amount. You must be realistic about what you can actually afford each month, and just because you have a home that costs $900,000 does not mean you can afford it!

Instead, a home in the low $600,000 range may be more feasible. This small adjustment can help you improve your chances of passing the stress test and obtaining mortgage approval. Most importantly, it can prevent you from using all of your income on a mortgage payment - there is such a thing as being house poor!

Evaluate Different Scenarios

If you want to be prepared to pass the mortgage stress test, try evaluating different scenarios ahead of time. Crunch the numbers and see if you could really manage an additional $500 payment if rates were to increase after approval. If you plan on obtaining a variable mortgage, then this is an absolute must.

The goal is to feel comfortable with the monthly payments that you will be required to make - whether or not they increase over the loan term. Avoid putting yourself in a situation where a slight increase in a mortgage payment would throw you into financial troubles.

Think about it this way - this is exactly why the Canadian government implemented the mortgage stress, to begin with!  

Is there any way to avoid the mortgage stress test?

The mortgage stress test can be an additional hurdle preventing you from buying your first home. Are there any ways that you can avoid the stress test? Technically there is!

This regulation was put in place for banks that are regulated by the federal government. Certain mortgage lenders like credit unions do not fall under this jurisdiction, which means they are not required to force their mortgage applicants to pass the stress test.

If you can't satisfy the mortgage stress test, an alternative subprime lending option may be best for you. The drawback to this is that interest rates are almost always higher at alternative lenders compared to traditional banks. Changes in the mortgage stress requirements have allowed these lenders to charge even more for their loans.

Before you move forward with one of these lenders, keep in mind that you may end up paying more in the long run due to higher fees and interest rates.

Other Real Estate Resources You May Be Interested In

A Guide on How to Buy A Home

First Time Home Buyer Incentives and Tips in Canada

Land Transfer Tax in Ontario

Land Transfer Tax in British Columbia

Mortgage Pre-Approval Process in Canada

What is Title Insurance?

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