Everything to know about the Mortgage Stress Test

Canada’s mortgage stress test applies to anyone applying for or renewing a home loan through a federally regulated lender. 

And apparently nearly half of Canadians (according to a poll conducted by TD Bank) don’t understand what the test is—or who it affects. Here’s your primer on the mortgage stress test!  

What is the mortgage stress test?

 The stress test is a set of rules major banks must use to determine if someone looking for a mortgage loan actually will qualify for a mortgage. Essentially, the stress test ensures the borrower will still be able to afford their mortgage payments even if interest rates increase. Put another way – the stress test is testing the financial strength of the borrower.

Why was the mortgage stress test created? And who does it affect?

Canada’s mortgage stress test was initially brought into effect by Office of the Superintendent of Financial Institutions (OSFI) in 2016. Initially, it only applied to insured mortgages - loans in which the borrowers had a down payment of less than 20% - which meant the potential borrowers were required to get mortgage default insurance. Given the high levels of household debt that Canadians were dealing with at that time (and continue to deal with), the theory was to use the stress test as a financial buffer for buyers facing a greater risk of not being able to make their mortgage payments in the future.

In 2018, the stress test was expanded to include buyers with more than a 20% down payment (those with uninsured mortgages). Since that time, all Canadian home buyers applying through a federally regulated lender (traditional banks) — as well as those refinancing their current mortgages or switching to a new lender — have needed to pass the test.

The stress rules have a far greater impact on aspiring homeowners or those bruised credit. And while new homeowners tend to be affected to a larger extent, the reality is that the rules apply regardless of the person looking for the mortgage loan – whether first time buyers or those that have bought and sold homes dozens of times.

The stress test rules have raised the minimum qualifying rate to over 6% - as a result of the most recent interest rate hikes - or two percentage points above the mortgage contract rate offered by the lender, whichever is higher. And with the possibility of more interest rate increases, the operative words are “whichever is higher”.

And remember - the mortgage stress test isn’t the only factor that goes into lenders’ mortgage calculations. To determine if and how much a borrower can afford to borrow, they will also look at the borrower’s existing debt load and credit score. And it’s all of these factors, combined with the stress test, that will cause the lender to place a limit on the amount that they will allow a borrow to borrow for their mortgage.

How does the mortgage stress test work?

When a borrower applies for a mortgage (including a reverse mortgage), the bank offers them a contract interest rate based on the current market interest rates. These rates are based on different economic indicators, such as the Bank of Canada’s benchmark interest rate.

Under the stress test, however, the borrower’s contract rate is NOT the rate the lender will use to determine your mortgage eligibility. Instead, the bank makes those calculations at a considerably higher interest rate in order to ensure that the borrower will be able to make your payments if or when rates go up.

An example of the how the mortgage stress test works

If a borrower is looking to purchase a home for $468,350, with a down payment of 20%, and to qualify for a five-year fixed-rate mortgage of 2.89%, then they would end up with a monthly mortgage payment of $1,752. And maybe for the borrower, that works for them.

But…. what if mortgage rates increase to 5.34% after the five-year term ends? According to the mortgage payment calculator (see below), the borrower’s monthly payment would increase to $2,252 (a difference of $500/month). And now the financial institution will want to know if they afford that rate TODAY.

Does the mortgage stress rules apply to all mortgage loans?

Absolutely not. While virtually all of the A, Alt A and B bank-type lenders are regulated and are obligated by OSFI to enforce the mortgage stress test, provincially regulated credit unions and alternative lenders (mortgage investment corporations and private lenders) are not so obligated.

What does it mean in practice for Canadian borrowers?

There’s little question that Canadian homebuyers in virtually every Canadian market will find that qualification under the stress test rate will be more challenging as interest rates increase making it more difficult (and in some cases, impossible) for some home buyers to obtain mortgage loans from traditional banks.

Some borrowers will be unaffected by the rising interest rates while, for others, it will become impossible to obtain a mortgage loan from federally regulated lenders.

How can Alternative Lending Solutions Help?

It's also important to keep in mind that many alternative lenders offer faster mortgage approval, even to borrowers with low credit scores and high debt-to-income ratio. Some, but not all, come with higher interest rates, but it still represents an opportunity for borrowers to get a short-term mortgage loan solution while they work at improving their credit and/or financial circumstances so that they can move from this short-term solution into a longer term solution. Additionally, many borrowers simply would rather not go to the bank because they only need capital for six months and would rather have a short-term relationship with the lender.

While private lending has been growing in popularity and respect over the years, with the challenges that Canadians have seen over the past 2 years in terms of terminations, lay-offs, furloughs, the rise of the housing market and dealing with the stress test, private or alternative lending has become more of a mainstream lending solution for certain borrowers.

The advantage of the flood of new private lenders is that has led to rates being reduced as a result of more competition – in many cases leading to borrowers borrowing costs that are, in many cases, marginally higher than those of institutional A-type lenders.

As you can see, due to the recent rate increases, use of the mortgage stress test now means more often exploring different options and strategies to help homeowners qualify for their home purchase or refinancing. There are different strategies for each unique situation irrespective of if the deal is going to an A, Alt A or B bank-type lender. Connect with us today so we can explore your options.

Sleep Easy Financial has access to 90+ mortgage lenders including the big banks. We beat the banks’ mortgages and our services are at no cost to you as we get paid by the lenders. Whether it’s for your next home purchase, mortgage renewal or refinance, our licensed mortgage professionals are committed to getting you your lowest rate so you save as much money as possible. We help you at every stage of the journey and are with you for the life of your mortgage. Be mortgage savvy and let us shop your next mortgage for you. Contact us or schedule your complimentary consultation today.

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