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Buying a home is a long-cherished dream of many Canadians. However, the process is not easy, especially with a limited income. You will have to look at all the options and related risks involved to make a safe decision. One of the things you mortgage stress test .
If you want to buy a new home in Canada, you will have to go through the mortgage stress test. It will determine how much mortgage you can get approved from financial institutions. It is also a legal requirement.
The test enables homeowners to know the size of the mortgage they can afford based on their current debts and income. We discuss the stress test below and other related factors in owning a new home.
What is the stress test in finance?
A stress test protects you from unpredictable and unfavorable conditions when you set out to buy property. It will require you to go through your present and future financial status to know the risk when you get a mortgage.
The test’s objective is to understand the impact of a mortgage on your finances. Let's say you are planning to invest in a registered retirement savings plan (RRSP). The RRSP can support you after retirement. But is it worth it? Can it pass the stress test?
With an RRSP, you can expect a 5% return from any of your investments. It is reasonable and is highly recommended for your future.
However, if you get a return of only 4% every year, it will not be worth considering. You will not have enough money to retire at 60. In that case, 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 of any investment before going through the process. The stress test will help you know whether an investment can meet your needs or not.
What is the mortgage stress test?
As its name suggests, the mortgage stress test will evaluate your mortgage-taking ability. It will decide how much mortgage you can afford in your current financial situation. For example, if you have lost your job or if your income has been significantly reduced, you might not be able to continue paying your mortgage. In this case, you will fail the test.
The mortgage stress test considers your current financial situation and future stability. It will see how you will manage when your circumstances change. Even if you can afford to pay the interest rate now but the test shows that you cannot pay higher interest in the future, you will fail the test.
It is worth mentioning that the interest rates and home prices 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.
You need to understand the market conditions and prepare yourself to pay the increasing cost. The mortgage stress test serves the same purpose. It will enable financers to know the repayment status of borrowers. They will know if you can afford to pay in the future or not.
Purpose of the mortgage stress test
When people are planning to buy a new home, they usually focus on their current financial status. However, a home is a lifetime investment, and you will have to consider future payments to avoid something unpredictable.
Interest rates, for example, increase with time, and homeownership costs must be paid. 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 will get approved for the mortgage. However, if you fail the test, you will not get it.
Therefore, you must understand the process before getting a mortgage for a new home. You can talk to a professional and understand how the mortgage stress test works. You can also go through the information below to know whether you can pass the test or not, and to be aware of what the banks will consider making a favorable decision.
How does the 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. It also 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.
The bank, however, 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, which has been increased to 5.25% in June 2021, up from was 4.79% in the previous years.
You can meet the qualifying rate with a high-paying job or other earning sources. However, your existing debt also needs to be low enough to meet that rate. That way, the bank will know that you can repay the mortgage at a higher rate.
Let’s assume, for example, that your contracted mortgage rate is 1.78%. 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: your contracted mortgage rate and your qualifying rate.
Say, for example, that you, the home buyer, have a $100,000 annual income. You need to pay 20% of the home price as a down payment, and you will have a 1.78% mortgage rate for 25 years. Through a mortgage affordability calculator, you will see that you will qualify for a mortgage for a home that’s worth $651,000 under the 5.25% qualifying rate.
Recent changes in qualifying rate
As mentioned earlier, the minimum qualifying rate is now 5.25%. All insured mortgages with a 20% down payment must pass the 5.25% qualifying rate. The higher qualifying rate will reduce the purchasing ability of homebuyers. It will also decrease the number of mortgages.
The Office of the Superintendent of Financial Institutions (OSFI), the financial regulator in Canada, 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 rate will fluctuate, including the home prices. Compare the cost between 2020 and 2021, for example. You will see that there is a sharp increase in the price. Therefore, you will have to prepare yourself for future expenses.
You can visit any leading website and compare mortgage rates. Also, you will have to understand that the interest rate might go up 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 its rate for the duration of the mortgage. You do need to be prepared for its adverse impact during the mortgage renewal.
As mentioned earlier, you cannot predict the interest rate in the future. It might increase by 2% to 3% in the next few years, and you may still be able to afford it. If the mortgage rate rises more than 5%, however, you may not be able to afford it.
Will you be able to manage the extra expenses with your savings? If so, that’s great. Otherwise, you will have to consider other available options. You can choose a lower-priced home, for example.
Does the mortgage stress test apply to all mortgages?
Yes, the mortgage stress test applies to both uninsured and insured mortgages. If you want one more mortgage to finance a new home, you will have to go through this test again. The objective 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.
Gross Debt Service Ratio (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%.
Total Debt Service Ratio (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 will know the percentage you use to repay your debts.
The TDS includes your loans, credit cards, student loans, car payments, and lines of credit. You need to have less than 42% to pass the test.
The bank will check the GDS and TDS to know your income and expenses. However, you can prepare yourself for a positive outcome before applying for a mortgage. You can pay your high-interest debts first to get them out of the way.
Apart from that, you can also 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 taking the mortgage stress test?
Yes, you can avoid a mortgage stress test. However, if you cannot pass that test, you cannot get a mortgage from any federally regulated bank, including the TD, RBC, and other big banks in Canada. You do have other options.
If you think you cannot pass a mortgage stress test, you can avoid taking it. You know your debts, monthly expenses, and income. If the GDS and TDS percentages are more, you should not take the test. Instead, you can consider taking a mortgage from unregulated lenders.
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 a mortgage. There will be several downsides, including a high interest rate of up to 10%.
The future of the test
The mortgage stress test has some stringent rules. The rules make it impossible for many to get mortgages. It has reduced the purchasing powers of potential homebuyers and have impacted the market. Therefore, there is increasing pressure on the OSFI to revisit the rules.
Canadian mortgage regulations keep changing. You might have noticed many changes in the last couple of years. Therefore, you will have to keep updated since any new rule can impact your mortgage rates.
Your safest course of action is to talk to experienced professionals about the mortgage stress test before buying a new home. These professionals can help you in your decision-making process. They understand the rules and market conditions and assist you in fulfilling your dream of buying a new home in Canada.