A common goal for many Canadians upon completing their education and gaining employment is purchasing their first home. Home ownership is, after all, the Canadian dream. While it’s general knowledge that saving money for a down payment is the first step to eventually purchasing a home, many are not aware of the mortgage stress test. So, what is the mortgage stress test in Canada, anyway?
To put it simply, the mortgage stress test is a mortgage qualifier tool used to determine if the borrower would still be able to continue making mortgage payments, should they lose their job, undergo some other type of financial strain, or if interest rates were to rise.
Before being approved for a mortgage on a home, the borrower must pass the mortgage stress test. Upon passing the mortgage stress test, the borrower can be pre-approved for a house loan.
However, the borrower may also choose to borrow funds through a credit union or another type of non-federally regulated lender, and in this instance, would not need to pass the mortgage stress test.
Even if you already have a mortgage, you may be required to pass this test. For example, if you refinance your home, change to a new lender, or take out a home equity line of credit (HELOC), your bank will require you to pass the test. Read on to learn more about the Mortgage Stress Test, including changes to the test that may impact your pursuit of the Canadian dream.
The Mortgage Stress Test
When discussing mortgage rates and purchasing a home, most people focus on the interest rate. This is because the interest you pay on a loan to buy a home adds up, and can potentially add hundreds of thousands of dollars to the cost of your home.
Some Canadians opt for a variable interest rate when purchasing their home. This means that the interest they pay over the length of the loan varies with a positive correlation to the Bank of Canada interest rate as it fluctuates. This variance adds uncertainty to the mortgage equation, meaning that banks and lenders want to eliminate as much risk as possible of a borrower not being able to pay the loan. In that, the mortgage stress test is used to determine the borrower’s risk associated with fluctuating interest rates.
Just last year, in June 2021, the qualifications to pass the stress test changed slightly. To pass the test now, the prospective borrower will have to be able to afford the higher of their contracted mortgage rate plus two per cent or a flat rate of 5.25 per cent. The flat rate is the standard rate used to qualify uninsured and insured mortgages. For example, if you are applying for a mortgage rate of three per cent, you would be assessed at the 5.25-per-cent rate, as that is higher than your rate plus two per cent.
The increase in the assessment rate for the stress test has decreased the purchasing power of many prospective homebuyers in Canada because they are being assessed at a higher rate than before. This means that in the past, someone would have been approved for a higher mortgage than they would be approved for now. This new assessment rate has also made it increasingly difficult for current homeowners to renew their mortgages. Combining the increased rate with rising prices and the financial effects of the pandemic, it is no wonder some Canadians are worried about mortgage approval.
Impacts of the Mortgage Stress Test on Canadians
While the increased qualifying rate for the stress test has helped limit the chance of mortgage loan defaults and therefore has decreased the uncertainty for lenders, it has made it more difficult for Canadians who want to buy a new home.
For example, if you want to apply for a mortgage loan of $750,000 at a five-year fixed rate of 2.75 per cent and an amortization period of 25 years, the lender will assess your affordability at 5.25 per cent, since it is higher than 4.75 per cent (2.75 per cent plus two per cent). That 5.25-per-cent rate would then be used to determine how much loan you could afford, even though it is quite a bit higher than the actual interest rate you would pay on your mortgage. When assessed at 5.25 per cent, you would be able to afford far less of a mortgage than you would be able to afford at your true interest rate of 2.75 per cent.
Taking all of this into consideration, if you are a prospective homebuyer, we recommend speaking to a mortgage professional or financial advisor to help you navigate the home-buying process. Further, a key takeaway is that the higher down payment you put on your home, the lower the mortgage required, minimizing the impacts of the new mortgage stress test.