Buying a home means fulfilling a long-cherished dream. However, the process will not be easy, especially with a limited income. You will have to go through all the available options and related risks to make a safe decision. You are here means you have come across the mortgage stress test. You want to know more about it. Yes, you will get the answers to all your queries in the following. The objective is to enable you to decide without any confusion.
What is a mortgage stress test? How does it help homebuyers in Canada? The mortgage stress test is a simple way to protect you from the worst. Also, it is a legal requirement in Canada. Therefore, you will have to go through it while buying a home. The test enables homeowners to know the size of the mortgage they can afford based on their loans and income. If you want to buy a new home, you will have to go through the mortgage stress test. It will determine how much mortgage you can get approved from financial institutions. Here is more about the stress test, mortgage stress test, and other related factors.
What Is the Stress Test in Finance?
A stress test protects you from unpredictable and unfavorable conditions. How does it work? The test will go through your present and future financial status to know the risk. The objective is to understand the impact on your finance. We can take a simple example. Let’s say you are planning to invest in RRSP. The retirement plan can support your life after retirement. But is it worth it? Can it pass the stress test? You can expect a five percent return from any of your investments. It is reasonable, and you can go ahead. But if you get only four percent each year, it will not be worth considering. You will not have enough money to retire at sixty. In that condition, it fails the stress test, and you can check other investment options to get more benefits. In brief, you will have to understand the profitability before any investment. The stress test will help you to know an investment can fit your unique needs or not.
What Is the Mortgage Stress Test?
As the test name suggests, it will test your mortgage-taking ability. It will decide how much mortgage you can afford in your current financial condition. For example, if you have lost your job or your income has reduced significantly, you might not afford to pay your mortgage. In that situation, you will fail the test. The mortgage stress test will consider your current financial condition and future stability. It will see how you will manage in changing circumstances. For example, even if you can afford to pay the interest rate now and cannot pay higher interest in the future, you will fail the test.
The mortgage stress test can prepare you for a rainy day. It is worth mentioning that the interest rate and the home price will not remain the same. The costs of both will fluctuate in most conditions. As stated by the Canadian Real Estate Association, the average home price of Canada was around \$695,000 in April 2021, and it was 41.9% more than the last year. Therefore, you will have to understand the market condition and prepare yourself to pay the increasing cost. The mortgage stress test serves the same purpose. It will enable financers to know the repay status of borrowers. They will know you can afford to pay in unfavorable financial conditions or not.
Purpose of the Mortgage Stress Test
Buying a home is the dream of everyone. But when we buy a home, we focus on our current earning status. However, a home is a lifetime investment, and you will have to consider future payments to avoid something unpredictable. The interest rates are increasing, and the homeownership costs are not exceptions. Just imagine, if the mortgage rate goes up after a couple of years, you will be in a financial crisis. This is what lenders want to avoid. They do a mortgage stress test to create a safe option for both of you.
The mortgage stress test will check your earning ability, expenses, and savings. If the test finds that you can pay high-interest rates in the future, you can get the mortgage. However, if you fail the test, you cannot get a mortgage. But, it is a must to understand the process before planning for a mortgage. You can talk to a professional and understand how the mortgage stress test works. Also, you can go through the following. You will know when you can pass the test and which things the banks will consider to make a favorable decision.
How Does Mortgage Stress Test Work in Canada?
Currently, the mortgage stress test applies to all mortgages in Canada. If you want a mortgage, you will have to pass the test. During the stress test, the banks will ensure that you can afford a home and pay higher interest rates when the market demands it. The test will decide your current and future paying ability. Also, it applies to joint mortgages. There will be no exception.
Once you apply for a mortgage, you will get a contracted rate. The rate may be as low as possible based on your current financial condition. But the bank will have to ensure that you can pay back the amount even if the interest rate rises during the loan term. They will check your repaying ability, and they will follow a few steps to determine your mortgage status. They will decide based on the qualifying rate of the Bank of Canada. The qualifying rate of the Bank of Canada was 4.79%. However, it became 5.25% in June 2021.
You can meet the qualifying rate with a high-paid job or other earning sources. Besides, your existing debt needs to be low enough to meet that rate. In these conditions, you can repay the mortgage at a higher rate. Here is a simple example of the mortgage stress test in Canada. Let’s assume your contracted mortgage rate is 1.78% in Canada, and the qualifying rate of the Bank of Canada is 5.25%. You might qualify for the lowest interest rate. But still, the bank will make its calculations for two specific mortgage rates. These are your contracted mortgage rate and qualifying rate.
The contracted mortgage rate and the qualifying rate of the Bank of Canada
Here your mortgage rate is 1.78%, and the qualifying rate is 5.25%
A mortgage affordability calculator result reveals a buyer with a $100,000 annual income, twenty percent down payment, and 1.78% mortgage rate for a twenty-five years mortgage term can qualify for a home worth $651,000 under the 5.25% qualifying rate.
Recent Changes in Qualifying Rate
As mentioned earlier, the qualifying rate was 4.79% before June 2021. But now, the minimum qualifying rate is 5.25%. Additionally, all the insured mortgages with a twenty percent down payment must pass the 5.25% qualifying rate. The higher qualifying rate will reduce the purchasing ability of homebuyers. Also, it will decrease the amount of mortgages. However, the financial regulator of Canada, OSFI, has said that they will review the qualifying rate every year.
How to Stress Test a Mortgage
It might not be possible to predict the exact interest rate in the current market condition. The interest rate will fluctuate, and the same is about homes. You can compare the cost between 2020 and 2021. You will notice a sharp increase in the price. Therefore, you will have to prepare yourself for future expenses.
You can visit any leading website and compare the mortgage rates. Also, you will have to understand that the interest rate might increase in the future. Any increase in variable-rate mortgages will impact your payments immediately. However, if you have taken a fixed-rate mortgage, it will maintain the low rate for the rest of the duration. But you can expect an adverse impact with the mortgage renewal.
As mentioned earlier, you cannot predict the interest rate of the future. It might increase two to three percent in the next few years. You might manage with this two to three percent increase. However, when the mortgage rate rises more than five percent, you might not afford it.
You can manage with your savings. Otherwise, you will have to consider other available options. You can choose a more affordable home.
Does the Mortgage Stress Test Apply to All?
Yes, the mortgage stress test applies to uninsured and insured mortgages. Also, if you want one more mortgage to finance a new home, you will have to go through this test. The objective of this test is to determine your current and future repayment status.
How to Pass the Mortgage Stress Test
You cannot do much when it comes to a mortgage test. However, if you understand the process, you can make things easier. Banks use the following criteria during a mortgage stress test.
GDS
The bank will check your Gross Debt Service Ratio. The objective is to know your monthly expenses, including utility bills, property taxes, and condo fees. All these costs will be added and divided by your monthly income. The lender will make sure that it is less than 32%.
TDS
The bank will go through your Total Debt Service Ratio. The ratio will reveal the amount you spend on repaying your debts. Hence, the lender can know the percentage you use to repay your debts. Also, the TDS will include your loans, credit cards, student loans, car payments, and lines of credit. The TDS needs to be less than 42% to pass the test.
The bank will check both these to know your income and expenses. However, you can prepare yourself for a positive outcome before applying for a mortgage. You can pay down your high-interest debts.
Apart from that, you can apply for a small loan. You should know how much you can afford even if the interest rate increases in the future. You should never apply for a mortgage that you cannot afford in unfavorable conditions.
Can I Avoid the Mortgage Stress Test?
Yes, you can avoid a mortgage stress test. However, if you cannot pass a mortgage stress test, you cannot get a mortgage from any federally regulated bank, including the TD, RBC, and Big Banks in Canada. But you will have other options.
If you cannot pass a mortgage stress test, you can avoid taking it. You know your debts, monthly expenses, and incomes. If the GDS and TDS percentages are more, you should not take the test. Instead, you can consider taking a mortgage from unregulated lenders. Yes, this option is there, and you can get a mortgage from private lenders. The private lenders will not do a stress test. They are flexible when it comes to lending requirements. Even if you have a bad credit score, you can get one. But there will be a few downsides. You will have to pay a high-interest rate of up to 10%.
The Future of the Test
The mortgage stress test has some stringent rules. The rules made it impossible for many to get mortgages. It has reduced the purchasing powers of potential homebuyers. Therefore, there is increasing pressure on the OSFI to revisit the rules. Also, the new rules have impacted the market. The ongoing conditions might prompt OSFI to review the regulations and bring positive changes.
Wrapping It Up
Canadian Mortgage regulations keep changing. You might have noticed many changes in the last couple of years. Therefore, you will have to keep an eye on the changes since any new rule can impact your mortgage rates. Additionally, you can increase the borrowed amount. When you have more money, you can save for adversities. Also, you can talk to experienced professionals.
There is no doubt that you will get a lot of information on the internet. You can have an overall idea about the mortgage stress test. However, experienced professionals can help you beyond your imagination. They understand the rules and market conditions. Therefore, they can enable you to get a positive result.
