How does a mortgage stress test work? A homeowner’s unique financial situation will determine the eventual interest rate a lender will finance on a secured mortgage loan. With potentially low rates, more Ontarians are looking to enter the housing market. Many current homeowners are also exploring the option of taking out second mortgages by tapping into existing equity.
Ontario has seen significant property appreciation, particularly in areas like the Greater Toronto Area (GTA), with increases over 30% alongside low mortgage rates. These gains can tempt homeowners to take out primary mortgages or use equity for secondary purchases. However, it’s crucial to understand how much mortgage debt you can handle to avoid financial strain or falling into arrears.
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 ago, banks could offer discounts on interest rates for various mortgage types, similar to current trends. Homeowners needed to assess affordability with even a 1% change in their mortgage rate. A mechanism was needed to forecast a borrower’s ability to pay mortgage payments if rates increase at renewal. So, measures were put in place in 2018. The government introduced mortgage stress tests for insured mortgages (those without the required 20% downpayment to avoid insurance).
A mere 1% increase in finalized interest rates can mean hundreds of additional dollars in monthly payments for Ontario homeowners. While some may manage these extra costs, others could face mortgage arrears and default due to increased financial strain. Banks do not want to be facing mortgage default on any scale if it can be avoided.
How Does a Mortgage Stress Test Work?
The mortgage stress test assesses how much debt a homeowner can manage with a potential increase in their mortgage rate. In essence, it’s a measure to mitigate lender risk and prevent mortgage default in case of rate increases. 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 measure determines what amount of housing cost a borrower can absorb relative to their income. Housing costs should not exceed 39% of a buyer’s total income.
- Total Debt Servicing Ratio (TDS)- This measure determines what housing costs can be absorbed based on monthly debt payments relative to income. Housing costs should fall under 44% when considering overall salary and any payments (credit cards, lines of credit, personal loans, etc.).
Does the Stress Test Apply to Mortgage Renewals?
While current homeowners with low rates may feel immune, new stress test rules apply when renewing or switching lenders. This slightly reduces current homeowners’ purchasing power, requiring them to meet new mortgage stress test rules with new lenders.
Why Do We Need Stress Tests?
Mortgage stress tests aim to moderate an overheated housing market and protect lenders against potential defaults on secured mortgage loans. Borrowers must show they can cover housing costs and other expenses to prevent mass mortgage defaults and support economic stability.
How Can You Prepare for a Stress Test
When shopping for a mortgage, ensure you’re financially secure enough to handle this significant commitment effectively. Here are some steps 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 need to borrow, resulting in better mortgage terms.
- Pay down as much household debt as possible, especially if you are considering taking out a second mortgage on an existing property.
- Know your credit report inside and out.
- Work to better your credit score.
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 at which the bank set the stress test in 2018 was 4.79%. Each borrower was scrutinized for their household debt ratio, income stability, and property value.
A borrower’s overall debt ratio determines if they can manage monthly mortgage payments, factoring in a potential 2% rate increase. A mortgage stress test serves as a financial forecasting tool, predicting how well borrowers can handle 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.
While obtaining mortgage financing may be more challenging, stress tests aim to prevent future financial difficulties. The goal is for borrowers to borrow responsibly, factoring in potential mortgage rate increases, a universal financial reality.
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. They can leverage a wide network of private lenders in the province to negotiate favourable terms on secured loans. Email ron@mortgagebrokerstore.com or call 416-499-2122.
