Mortgage Stress Tests in Canada

Interest Rates May remain Low for Now but Mortgage Stress Tests are Set to Head Northward

For the better part of 16 months interest rates on both variable and fixed mortgage types have dropped significantly compared to pre-pandemic levels. In the first quarter of 2021 mortgage rates remain exceptionally low. Homeowners looking to renew their mortgages and Ontario borrowers seeking to profit from the robust Ontario housing market can find rates as low as 1.53% on a 2 year fixed mortgage type.

Of course, a homeowners/borrower’s unique financial picture will help to determine the eventual interest rate a lender will finance on a secured mortgage loan. With rates potentially this low, the number of Ontarians that want to enter the housing market has been increasing. So are the numbers of current Ontario homeowners that want to explore the option of taking out second mortgages on their properties by tapping into existing equity.

Coupled with low mortgage rates, Ontario has also seen property appreciation increase dramatically in the last year into the double-digit territory (some areas including the GTA have seen appreciations exceeding 30%.) 

With property gains in these numbers, it may be tempting to try to take out either principal mortgages on new properties or utilize equity to purchase secondary properties. It is important, however, to know what amount of mortgage debt you can manage without finding yourself house-poor or worse fall into arrears as rates slowly creep back up. 

Mortgage Stress Tests are Set to Become Harder to Pass- Know What You Can Afford

The Federal Government and the Bank of Canada have recognized the danger of taking on too much mortgage debt for several years now. A few years back, similar to what we are currently experiencing, the banks could afford to offer discounts on associated interest rates on different mortgage types. There became a need to assess what a homeowner could truly afford given a change of even 1% in their mortgage rate.  A mechanism was needed to try to forecast a borrower’s ability to pay monthly mortgage payments if there were to be a change upwards in the rate at the time of mortgage renewal. So measures were put in place in 2018. The Government introduced mortgage stress tests for those with mortgages that were insured (mortgages that did not have the required 20% downpayment to avoid being insured.)

The difference in monthly payments for an Ontario homeowner with only a 1% increase on their finalized interest rate can represent hundreds of additional dollars. Some may be able to handle these additional expenses, while others could be at threat of falling into mortgage arrears and defaulting on their mortgage as a result. Banks do not want to be facing mortgage default on any scale if it can be avoided. 

What Exactly is a Mortgage Stress Test?

Although commonly referred to as a “Stress Test” what the banks are essentially saying is: Can you handle payments with an increase in your mortgage rate? The rate that the bank set the stress test at in 2018 was 4.79%. So in effect, each borrower would be scrutinized in terms of the overall household debt ratio, degree of income, and overall price of the given property to see if payments could sustain rate hikes at this level. 

A borrower is assessed in terms of their overall debt ratio to determine if monthly mortgage payments can be absorbed along with any other monthly liabilities with a potential increase of roughly 2% on their current mortgage rate. A good way to perceive a mortgage stress test is that it effectively represents a method of financial forecasting taking into mortgage rate changes.

Canada’s top banking regulator has recently announced that that starting June 1st the magic number will be hiked up even further to 5.25% or a full 2% higher than the current rates (which fortunately remain very low). 

It is estimated that the original stress test of 4.79% represented in 2018 a decrease of up to 18% of a borrower’s/homeowner purchasing power. With the expected increase to 5.5%, the reduction in purchasing power is assessed to be minimal for potential borrowers at roughly a 4% decrease.

Although the criteria while seeking mortgage financing may be even harder to pass, ultimately the stress tests are in place to try to avoid financial pain down the road. The goal being for borrowers to only borrow what they can truly afford even with increases to current mortgage rates which is always a financial reality for any borrower and existing homeowner.

How Does a Mortgage Stress Test Work? 

The mortgage stress test is based on calculating what amount of debt a homeowner can comfortably take on based on an increase to their negotiated mortgage rate. It is, in other words, a measure that is designed to mitigate risk for the lenders and avoid the possibility of mortgage default if the rates were to increase. To properly forecast the financial wiggle room a borrower will have with a mortgage rate increase lenders base the test on two widely used debt measures:

  • The Gross Debt Servicing Ratio (GDS)- This first measure determines what amount of housing cost a borrower can absorb relative to their income. The housing costs should not exceed 39% of a buyer’s total income.
  • Total Debt Servicing Ratio (TDS)- This second measure determines what housing costs can be absorbed based on monthly debt payments and relative to income. Concerning outstanding debt, housing costs should fall under 44% when taking into account the overall salary and any payments (credit cards, lines of credit, personal loans, etc.

Does the Stress Test Apply to Mortgage Renewals?  

Although current homeowners that may have locked in very low rates may be feeling slightly immune to the new stress test mortgage rules, these new numbers do apply to those homeowners that are looking to renew their mortgage and are switching lenders with their upcoming mortgage renewal. This will slightly reduce the purchasing power of current homeowners as they need to pass the new mortgage stress rules with a new lender

Why Do We need Stress Test?  

The reasons for implementing mortgage stress tests generally boil down to specific measures that will help to effectively slow down a very overheated housing market. These measures also applied due to the need for lenders to be protected against any potential future default of secured mortgage loans.

Being able to demonstrate the ability of borrowers/homeowners to comfortably pay all housing costs in addition to all household monthly expenses is paramount to maintaining a healthy housing market and positively impacts the economy as mass mortgage default can be avoided with proper risk mitigation imposed by mortgage stress tests.

How Can You Prepare For a Stress Test

As in anything in life, all ducks must be in a row to ensure success. If you are in the market to shop for a mortgage loan, it is best to be in a very comfortable financial position to take on such a major loan. What can you do to improve your chances of passing?

  • Save as much as you can for a downpayment. The more you put down for your home purchase, the less you will have to borrow and this will give you the most favorable terms on a mortgage.
  • Make sure you pay down as much household debt you can. This also applies if you are looking at taking out a second mortgage on an existing property.
  • Know your credit report inside and out. 
  • Work to better your credit score

Mortgage Broker Store Can Help with Private Mortgage Loan Options

With more stringent rules soon to be implemented for those with insured mortgages and those switching lenders at the time of renewal, Mortgage Broker Store can help negotiate short-term private mortgage loans to help if credit is an issue or your debt load is too high to pass the bank’s new mortgage rules. With access to a broad network of private lenders across the Province that will be able to sit down with you and negotiate favorable terms on secured private loan options.

About Jonathan Alphonso

Mortgage Agent, Web Developer, and Real Estate Investor. Together with Ronald Alphonso I run MortgageBrokerStore.com. I write about a variety of topics on Canadian mortgages and real estate. Our particular specialty is dealing with Ontario power of sale and foreclosure situations.