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Mortgage Stress Test in Canada: A comprehensive overview

An in-depth guide provides the comprehensive overview of the stress test in Canada: How to calculate, when is it applied, its impacts, and more.

The mortgage stress test has transformed home affordability and purchasing power for an entire generation of Canadian homebuyers. Being implemented nationally in 2018, this stress test is now engrained as a mandatory component of the mortgage approval process.

This in-depth guide aims to provide homebuyers, owners, and advisors with the most comprehensive overview of the stress test. We will cover:

  • What is the mortgage stress test? When is it applied?
  • The impacts of mortgage stress test
  • Options if you can’t pass the mortgage stress test
  • Tips for preparing for the stress test or to avoid it

Read on for clarity on how the stress test works and how you can best prepare for it on your home-buying journey.

What is Canada Mortgage Stress Test?

WHAT IS CANADA MORTGAGE STRESS TEST
What is Canada Mortgage Stress Test?

Known officially as the mortgage rate qualification rule under OSFI Guideline B-20, the stress test requires homebuyers to qualify for a mortgage at an interest rate higher than what they will actually pay. This is done to buffer for future rate increases that may occur over the mortgage term.

When applying for a mortgage, the stress test interest rate is determined as follows:

  1. Determine your contracted mortgage interest rate offered by the lender
  2. Add two percentage points to that contracted rate
  3. Compare the sum to the current stress test minimum rate set by OSFI, currently at 5.25%
  4. The higher of the two rates is your stress test rate

(Source: https://www.osfi-bsif.gc.ca/en/guidance/guidance-library/minimum-qualifying-rate-letter-2021)

For example:

  • If your contracted rate is 4.55%, your stress test rate is 4.55% + 2% = 6.55%
  • If your contracted rate is 5.10%, stress test rate is 5.10% + 2% = 7.10%
  • In both cases, the calculated rate exceeds the 5.25% minimum, so the higher calculated rate is used.

This higher stress test rate is what determines the maximum mortgage amount and home price a buyer can qualify for.

By testing mortgage affordability at a hypothetical higher rate, borrowers are proven to have a cushion in case rates rise in future before they renew.

This promotes responsible borrowing by preventing Canadians from taking on excessive housing debt relative to income, thus, protecting both the lender and borrower alike.

When is Mortgage Stress Test Applied in Canada?

The stress test is required in the majority of common home-buying and mortgage situations:

  1. Purchasing a Home: All borrowers are stress tested when purchasing a home, whether making a down payment above or below 20% of the price.
  2. Mortgage Refinancing: Borrowers must redo the stress test when refinancing an existing mortgage, whether with their current lender or a new lender.
  3. Switching Mortgage Lenders: Stress test applies if you switch your existing mortgage to a new lender, unless renewing an insured mortgage as outlined further below.
  4. Obtaining a HELOC: Taking out a new home equity line of credit also requires passing the stress test again.
  5. Renewing with Existing Lender: An exception – borrowers can renew for a new mortgage term with their existing lender without undergoing another stress test.
  6. Renewing and Switching Lenders: There is a distinct stress test policy for borrowers who switch lenders at renewal time.
    • Uninsured mortgages (down payment over 20%) MUST redo the stress test when switching lenders on renewal.
    • Insured mortgages (down payment under 20%) do NOT require re-testing when switching lenders at renewal.

This nuance is due to the insured status keeping risk with the mortgage insurer.

How does Mortgage Stress Test Impact Mortgage affordability?

By testing repayment ability at higher interest rates, the stress test reduces the maximum mortgage amount, and hence home price, that a borrower can qualify for. For example:

Without Stress TestWith Stress Test
Mortgage Rate4.5%6.5%
Home Purchase Price$500,000$430,000
Down Payment (20%)$100,000$86,000
Mortgage Required$400,000$344,000
Impact of Stress Test on Maximum Home Price

In this example, the stress test rate increases the required down payment amount by $14,000 and decreases the maximum qualified home price by $70,000 for this hypothetical buyer.

Their income can support a higher priced home when tested at a lower rate. But under the stress test, buyers are forced to opt for a lower priced property or save a larger down payment.

How are Maximum Mortgage amounts determined?

Lenders determine maximum mortgage amounts and home prices borrowers qualify for using two key debt service ratios:

Gross Debt Service (GDS) Ratio

The GDS measures total housing costs divided by gross household income. As a rule of thumb, the GDS should not exceed 32% for insured mortgages or 39% for conventional mortgages.

Total Debt Service (TDS) Ratio

The TDS measures total debt obligations divided by gross household income. This includes housing costs plus all other debts like car loans and credit cards. The TDS limit is typically 44%, but depends on individual factors.

When applying the stress test, lenders determine these ratios based on the higher stress test interest rate. This is what constricts the maximum mortgage amount the borrower is deemed to comfortably support.

Mortgage Stress Test for First-time Home Buyers

The stress test can significantly impact the purchasing power of first-time home buyers. Consider the following:

  • First-time buyers have smaller down payments, relying heavily on insured mortgages
  • Their average down payment was just 8% of the purchase price in 2023

(Source: https://citadelmortgages.ca/average-down-payment-for-a-house-in-canada)

  • But they must still qualify at much higher stress test rates with these smaller down payments

The impact is that some first timers may be priced entirely out of the market. Others must settle for far lower priced properties than expected. Coming up with larger down payments can help ease the stress test burden if possible.

For other buyers, the stress test may push affordable home prices much lower than expected. Coming up with a larger down payment is an option but can be difficult to accumulate, leading to frustration.

Critics argue the stress test has made home ownership unattainable for many younger Canadians looking to enter the market. However, regulators still see strong value in maintaining responsible lending standards.

This necessitates very large mortgages relative to incomes for new entrants while applying stringent stress test qualification criteria.

How to Evaluate Stress Test Readiness Before Applying?

Evaluate Mortgage Stress Test Readiness
Evaluate Stress Test Readiness

Prospective buyers can evaluate their mortgage eligibility and stress test readiness in a few ways prior to actual application:

  • Online Mortgage Affordability Calculators

Various tools allow inputting personal financial scenarios to estimate maximum approval amounts and required down payments.

  • Mortgage Pre-Approval with Broker

Reputable brokers offer pre-approvals to assess affordability and provide the maximum mortgage you qualify for.

  • Review Budgets and Credit

Buyers should optimize their budget and credit score before applying, as both impact rates offered and stress test outcomes.

Getting pre-approved provides the most reliable estimate of both approval amount and qualification for the stress test.

Do NOT Pass the Mortgage Stress TestWhat to do?

For hopeful buyers who don’t qualify for their desired mortgage amount under the stress test, there are some options:

  • Increase Down Payment

Contributing more upfront lowers the mortgage required. This improves the chances of being able to meet debt ratios at higher stress test rates.

  • Improve Credit Score

A higher score qualifies borrowers for lower interest rates. Since the stress test rate is a set premium above the contract rate, improving credit to get better contract rates makes passing the stress test easier.

  • Purchase Lower Priced Property

Opting for a less expensive property lowers the required mortgage amount borrowers need to qualify for.

  • Alternative Lenders

Certain credit unions or private lenders may provide mortgages without requiring the federally mandated stress test.

Coming up with a larger down payment through added savings, gifts, or other means is generally the simplest option. The lower mortgage required will increase the chances of qualifying under the strict stress test.

How to Avoid the Mortgage Stress Test?

While difficult, some limited scenarios exist where borrowers can avoid the stress test:

  • Renew with Existing Lender

Mortgage renewal with an existing lender, whether insured or uninsured, does not require undergoing another stress test.

  • Provincially Regulated Lenders

Some smaller credit unions not overseen by OSFI may have stress test exemptions, especially for borrowers with 20%+ down payments.

  • Alternative/Private Lenders

Unregulated lenders like mortgage investment corporations may offer mortgages without requiring the stress test.

  • Larger Down Payment

A down payment of at least 20% also opens access to credit unions and alternative lenders who may waive the stress test for uninsured mortgages.

But the vast majority of buyers will be required to pass it when dealing with mainstream regulated lenders. Having a larger down payment or renewing with your existing lender are the simplest ways to avoid the test.

How does Mortgage Stress Test Differ for Refinancing vs. Renewals?

Mortgage Stress Test Differ for Refinancing vs. Renewals
Mortgage Stress Test: Refinancing vs. Renewals

Refinancing a Mortgage

Borrowers must complete a new stress test when refinancing, regardless of staying with their existing lender or seeking a new lender. Refinancing is subject to full re-underwriting.

Renewing with Existing Lender

No stress test is required if simply renewing a mortgage with the existing lender. Unless other parameters like the amortization period change, it is exempt.

Renewing and Switching Lenders

As outlined earlier, only unisuredmortgages (down payment over 20%) must redo the stress test when switching lenders on renewal.

Insured mortgages (down payment under 20%) are exempted from stress testing when switching lenders at renewal. The mortgage insurer retains risk.

Read more: Mortgage renewal in Canada

Criticism and Calls for Changes to the Stress Test

While now an accepted part of the mortgage market, the mortgage stress test has drawn criticism and calls for reform from various groups:

  • Housing advocates argue it harms affordability and prevents market entry, especially for younger first time buyers with limited down payment savings.
  • Mortgage industry stakeholders say it restricts refinancing and lender switches, limiting competition and consumer choice.
  • Regulators believe it remains a necessary prudence measure and have not publicly indicated plans to eliminate it. They are open to moderate tweaks to improve flexibility.

With higher interest rates at the forefront of our minds today, the prudence of testing repayment ability at higher qualifying rates is newly justified. It remains contentious, but the merits continue to outweigh critics’ concerns for policymakers.

Potential Future Policy Changes

While not expected to be abolished, there are certain potential changes policymakers are considering for the stress test policy:

Waiving Stress Test for Uninsured Renewals

This would exempt borrowers who switch lenders at renewal but have 20%+ equity from redoing the stress test. Proponents argue this encourages competition between lenders.

However, Canada’s banking regulator indicated there will be no imminent changes to the requirements of the stress test despites they acknowledged that there is an unequal application of the mortgage stress test for certain homeowners renewing their mortgages.

Introducing a Maximum Loan-to-Income Ratio

An additional ratio measuring total debt against income would complement today’s GDS and TDS ratios in assessing affordability.

Updating the Minimum Qualifying Rate More Frequently

OSFI reviews the defined minimum stress test rate annually. More frequent adjustments could allow it to better track market shifts.

Overall, significant changes are viewed as unlikely in the near term. Modest adjustments may be implemented to balance prudence and flexibility amidst critics and advocates.

Key takeaways – Preparing for Canada Mortgage Stress Test

The mortgage stress test is an established pillar of the home financing process, impacting millions of buyers. All prospective borrowers should understand the key aspects:

  • Required by all mainstream regulated lenders when financing a home
  • Reduces maximum mortgage amount by testing on higher hypothetical rate
  • It can be very restrictive for first-time buyers with smaller down payments
  • Work on improving credit, budgeting, and down payment savings before applying
  • Get pre-approved to both confirm the true maximum amount and prepare documentation

While some criticism remains, understanding and preparing for Canada’s mortgage stress test is absolutely crucial to navigate the market and financing landscape for today’s home buyers. It has transformed housing affordability and requires proactive planning to overcome its stringent effects.

Understanding the policy and its rationale, buyers can best ready themselves and work with mortgage advisors to craft strategies maximizing affordability, overcoming the stress test on your home buying journey.

FAQs

What is mortgage stress test in Canada?

The stress test requires borrowers to qualify for a mortgage at an interest rate higher than their actual contracted rate. It assesses ability to pay if rates rise.

When does stress test apply?

It applies to most situations - purchasing a home, refinancing, switching lenders, and taking out a HELOC. Renewing with the same lender is exempt.

How is stress test rate calculated?

It is the greater of the borrower's contracted rate + 2% or the OSFI minimum stress test rate, currently 5.25%.

How does mortgage stress test impact maximum borrowing?

It lowers the maximum mortgage amount and purchase price qualified for by testing affordability at a higher rate.

First-time home buyers affected most by stress test?

Yes, first timers with smaller down payments rely on insured mortgages but must still meet stringent stress test criteria.

What if you can't pass the stress test?

Options include a larger down payment, improving credit score, buying a lower priced property, or seeking alternative lenders.

Can borrowers avoid stress test?

Difficult, but possible by renewing with the same lender, provincially regulated lenders, private lenders, or 20%+ down.

Does mortgage stress test apply to refinancing?

Yes, it is required when refinancing a mortgage regardless of using existing or new lender.

How can you prepare for the stress test?

Improve credit, budget, down payment savings. Get pre-approved to confirm maximum borrowing.

Will the stress test be changed or removed?

Unlikely to be abolished but moderate tweaks are under consideration to improve flexibility.

Article Sources
  1. Mortgage stress test in 2024: Everything you need to know – ratehub.ca
  2. The Mortgage Stress Test: How to Calculate Your Qualifying Rate – nerdwallet.com
  3. What is the Canadian mortgage stress test – scotiabank.com
  4. Mortgage Stress Test: What is it and how does it work? – truenorthmortgage.ca

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