The stress test can be a barrier for many Canadians seeking a mortgage. Traditional banks and other federally regulated lenders require and set a mortgage qualifying rate based on it.
Alternative loans are often accessible, flexible solutions that can bypass the stress test. They have other benefits, and understanding them helps.
What Is the Mortgage Stress Test and Why Is It a Challenge?
The mortgage stress test applies to anyone applying for a mortgage, renegotiating the terms of an existing one, or working with a federally regulated lender. It’s designed to gauge whether people applying for a loan from a bank or credit union can afford their payments if the interest rates or their financial situation change.
There’s a mortgage qualifying rate involved, which is the number that you need to be at to pass the test. Many traditional lenders use an interest rate based on the one you first negotiated with a lender plus 2% or 5.25%, whichever is higher.
It’s a challenge because it can reduce the size of a mortgage that many borrowers qualify for. The stress test can lower the maximum purchase price unless you create a more significant down payment to make up the difference.
How Do Alternative Lenders Bypass the Stress Test?
Alternative lenders don’t fall under the same federal regulations that require the stress test as more traditional banks. Instead, The Ontario Mortgage Brokerages, Lenders and Administrators Act (MBLAA) is the legislation that regulates mortgage brokers and private lenders if the private lenders themselves are not mortgage brokers. Ontario’s Financial Services Regulatory Authority (FSRA) oversees both parties to ensure they are in accordance with the Act.
Who Can Benefit from Using Alternative Lenders?
The same federal legislation does not regulate private or alternative lenders like banks. They also don’t adhere to strict income guidelines and credit scores when accepting or rejecting applications. Because loans are based on the equity in a property, they have more flexibility and appeal to a different set of applicants.
Applicants with bad credit are included. According to Equifax, a credit score below 560 is poor.
Alternative lenders sell products that benefit people with non-standard incomes, including sole proprietors and gig and contract workers.
Other people benefitting from these alternative loans include homeowners who need money for emergency repairs or renovations. Sorting through all the information to make a good decision about a private lender means considering the bonuses and negatives.
The Pros and Cons of Using Alternative Lender
If you’re considering one of these loans, you must balance the pros and cons.
Pros
- Private lenders have more flexible criteria. They are willing to consider people with non-traditional income sources, such as contract workers, self-employed individuals, and seasonal workers.
- These types of lenders can also supply bridge financing over the short term. This is great for investors who are looking for new properties and have a certain timeline to close a deal.
Overall, these private loans increase the chance of approval for borrowers who’ve been rejected by traditional banks. People who have found themselves facing a power of sale or foreclosure can get the money to stop the process.
Cons
- Because these loans are usually only one year and incorporate interest-only payments, an exit strategy is a good idea for a borrower. Private loans can help you avoid the stress test and get money to solve some financial problems. However, it’s a good idea to consider other measures to fix your finances, like budgeting and refinancing.
- It’s important to consider that there’s still a risk of a power of sale or foreclosure. These alternative loans are on shorter timelines, and borrowers can still receive a Notice of Sale. That happens if they break the mortgage agreement by missing payments or breaching a covenant, like purposefully damaging the property.
Higher interest rates are always something to consider. For example, as of September 2024, most private lenders charge between 8% and 12% for interest rates. That rate often depends on how close the requested mortgage is to the high-end Loan to Value (LTV) ratio. Most private lenders will go up to 75% as a maximum of this ratio. The LTV measures the amount of all the requested and other loans compared with the property’s appraised value.
One of the other areas that needs to be looked at is the fees. These can include legal fees, broker fees, and lender fees, which can also be impacted by the LTV. The range here can go from 4% to 8% of the total amount of the loan.
There are differences between traditional lenders and their alternative counterparts. That’s why choosing a private lender requires checking a few unique boxes.
How to Choose the Private Mortgage Lender
Choosing the right alternative lender means starting by looking at their reputation. One good way to check credibility is to look at customer testimonials on a website. Trusted mortgage brokers can also offer recommendations to private lenders.
Make sure they advertise the kind of specialized loan products that you would need from a private loan. People looking for this type of financial help might need a second or bad credit mortgage.
Understanding alternative lenders means understanding how they can bypass the stress test with a different set of requirements. Taking the time to understand who benefits most from these types of loans will help you make a good choice. Going through the pros and cons of a private loan will give you the information you need.
