Mortgage Stress Tests are Set to Become Harder to Pass in Canada

Although we have been clawing our way out of a prolonged pandemic, 2020 defied all logic when it came to the developments in the housing sector across Ontario and the country as a whole. In some areas of Ontario, primarily the extremely robust GTA and surrounding areas of Hamilton and Burlington, 2020 and the first quarter of 2021 have seen gains in housing appreciation in the double digits territory.

In May 2021, the price of a single-detached home in the GTA rose by 28.4% as compared to May 2020. This dramatic year-over-year increase puts that average selling price at $1,108,453. Even in the short span of a month between April and May 2021 houses increased by 1.1%.

Coupled with a housing market in overdrive, mortgage 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 can take advantage of rates as low as 1.53% on a 2-year fixed mortgage type for example.

These factors have helped create a perfect storm for those that are eager to take out principal mortgages to purchase Ontario property and for existing homeowners that are looking to low rates when renewing mortgage terms. It is important to keep in mind that the eventual interest rate a lender will finance on a secured mortgage loan depends largely on the particular financial circumstances of the borrower/homeowner.

Those homeowners that are wanting to lock in historically low rates on mortgages up for renewal or those borrowers that are looking to secure mortgage financing need to be wary of the potential financial pitfalls of taking out too much mortgage if rates start heading northward. The amount of mortgage debt you can manage without finding yourself house-poor or worse fall into arrears as rates slowly creep back up is crucial to maintain good financial standing.

Know What You Can Afford

When similar factors converged back in 2016 warning bells were rung by the Federal Government and the Bank of Canada. The BOC was cognizant that there was a potential looming danger if too many borrowers took on too much debt. Although the banks could afford to offer discounts on associated interest rates on different mortgage types it was evident that there needed to be an effective measure instituted to try to prevent borrowers from getting in over their head if mortgage rates were to increase.

Even an increase of 1% increase in a prospective borrowers/homeowners mortgage rate could spell financial strain that would leave some unable to pay reliably their monthly mortgage payments which would increase considerably to the tune of hundreds per month potentially.

A mechanism was needed to forecast a borrower’s ability to pay monthly mortgage payments if there were to be a change upwards in the rate at 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.)

If mortgage payments were to increase, some borrowers/homeowners would be at risk of falling into mortgage arrears and defaulting on their mortgage as a result. Certainly, it is in the banks’ best interest to make efforts to avoid high numbers of mortgage defaults.

What Exactly is a Mortgage Stress Test?

What the banks refer to as a “Stress Test” is simply a financial measure that is implemented to determine what a borrower can truly afford. What the banks are essentially asking 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%. A borrowers’ financials would be assessed in terms of the overall household debt ratio, degree of income, and overall price of the given property to see if payments could sustain the rate increases at this level.

The banks are assessing a borrower’s overall debt ratio to determine if monthly mortgage payments can be reliably covered in addition to any other monthly liabilities with a potential increase of roughly 2% on their current mortgage rate. What a mortgage stress test can do is reliably forecast a borrower’s ability to pay monthly mortgage payments given a change in the monthly mortgage rate associated with their mortgage loan.

Fast forward to 2021. Canada’s top banking regulator has recently announced that starting June 01st, 2021 the benchmark number of 4.79% will be increased to 5.25% or a full 2% higher than the current rates (which fortunately remain very low).

How much does this increase affect the purchasing power of an average borrower? It is estimated that the original stress test of 4.79% represented in 2018 a decrease of up to 18% of a borrower’s/homeowners 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 current change may represent far less of a dent in purchasing power, it is necessary to try to help avoid mortgages being loaned to those that may not be able to reliably make payments with a rate increase.

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?

To understand why borrowers are subject to stress tests it is important to view the measure as a financial risk assessment. The mortgage stress test is based on calculating the overall risk. Specifically, it is designed to mitigate risk for the lenders and avoid the possibility of mortgage default if the rates were to increase. The banks are asking what amount of debt a homeowner can comfortably take on.

The mortgage stress test is based on:

· 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?

Questions may arise as to whether current homeowners that are holding mortgages up for renewal may be affected by the new changes to the mortgage stress test. The answer is yes and no. If a homeowner is not happy with their current lender or may be looking to another lender to lock in a lower rate for the next mortgage term then they will be put through mortgage stress tests with the increased interest rate benchmark.

If a homeowner simply renews their mortgage with their existing lender, then a mortgage stress test is not required.

Why Do We need Stress Test?

· To help to effectively slow down a very overheated housing market. Mortgage stress tests help to serve as effective cooling measures to help stabilize borrowers borrowing beyond their financial means.

· 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?

What can you do to improve your chances of passing?

  • Make a list of your monthly liabilities.
  • Gather all necessary documents including proof of salary, additional assets.
  • Know your credit report inside and out.
  • Work to better your credit score.
  • Save as much as you can for a down payment. 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.

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.

Mortgage Agent, Web Developer, and Real Estate Investor. Together with Ronald Alphonso I run MortgageBrokerStore.com. I write about mortgage related topics.