What Is The Canadian Mortgage Stress Test?
A mortgage stress test provides an estimate of how much financial burden you can bear during adverse conditions like interest hikes. You need to meet the bank/lender to clear the test before approval.
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The mortgage stress test is to prepare you for the worst-case scenario. As a part of the mortgage stress test, buyers need to give a face-to-face test with the bank/lender before they approve your mortgage.
A mortgage involves long-term payment liability. During the mortgage terms, the interest rate may rise. Lenders conduct a mortgage stress test to evaluate if the borrower can pay the mortgage at the current interest rate. They also check if the borrower can pay even when the rate is hiked by up to 2 percent.
Homebuyers need to depict that their finances help them sustain the payment for the mortgage even if there is a significant interest rate hike. Lenders will closely scrutinize the finances and the home buyer’s ability to pay the mortgage before approving your mortgage.
The Reason for Mortgage Stress Test Implementation
The test is to ensure the borrowers have the finances to afford the mortgage even after an interest rate hike by the regulator.
Why Mortgage stress test is important for lenders and buyers?
Considering Canada’s average home price of $500000 which is up by 11 percent as compared to the last year’s price, the mortgage interest rate fluctuates, so do the home prices. The stress test is used to avoid making costly mistakes while making an investment decision.
Example of a mortgage test Questionnaire
The lender will prepare a questionnaire and will ask you to answer it. The questionnaire may be time-bound.
Here are a few sample questions in the questionnaire:
- Whether you are a first-time buyer
- The credit/loan amount you are seeking approval for
- The purpose of the home, for example, residential/investment/second home
- Stage of the home purchase (signed/still shopping/make an offer)
- The estimated home price & down payment (% of payment/minimum)
- Your age, occupation, Gross annual household income
- Your financial standings (applied bankruptcy in the past)
- Buying through real estate agent/broker/owner
- Your personal and contact details
How does Mortgage Stress Test work?
Most first-time buyers look for high ratio mortgages. High ratio mortgages are the ones with a down payment of less than 20 percent of the purchase price of the home. A high ratio refers to the ratio between the mortgage/loan amount and the total purchase price/value.
When you apply for a mortgage or joint mortgage, the lender will offer you a contracted rate. This rate is possibly the best and the lowest. The lender’s top priority is to check if you can pay back your mortgage, even if the rate rises during the mortgage term.
The lender will check your finances and ability to pay based on the bank’s qualifying rate. The qualifying rate is the average of the 5-year fixed-rate posted by leading Canadian banks. The current qualifying rate is 4.79 percent.
The two factors that play the decisive role are your income high enough and your debt low enough to pay down your mortgage at a rate higher than 4.79 percent to qualify and pass the stress test.
How will Canadians deal with the Mortgage Stress Test in 2021?
Canada’s top lenders and regulators propose that 5.25% or 2% above the market rate or whichever is higher, for the mortgage stress test. The current rate is 4.79 percent, which is the average lending rate posted by Canada’s biggest banks/lenders.
You need to support your claim of consistent payment of mortgage for the time you are taking it for. If you cannot prove it to the satisfaction of the lender, you will fail in the mortgage stress test.
Example of the impact of mortgage rates hike
For example, at 2 percent on a 25-year mortgage of $300000 would cost you $1270 per month. At 4.79 percent the same would become $1709 per month, up by $500. At 5.25 percent, the monthly payment rises to $1788.
As the home prices and interest rate will fluctuate over a 5-year mortgage period. You need to show that your financial arrangements can withstand a significant hike in the rates payable.
If you cannot show it satisfactorily, you will fail the test. Subsequently, the lender will find you eligible for the mortgage.
Two methods to determine the maximum amount you can borrow.
Lenders use two methods: Gross Debt Servicing Ratio (GDS) and Total Debt Servicing Ratio (TDS)
GDS measures how much the housing costs vis-à-vis your gross annual household income. TDS measures how much housing debt you can take considering all other debts compared to your gross annual household income.
GDS is up to 39 percent of your gross annual household income. This means 39 percent of your income should go towards your housing expense. This includes mortgage payment at the stress test rate, property tax, heat, and half of condo maintenance fees.
TDS considers all your debt repayment. This includes mortgage payment at the stress-tested rate, credit cards, car loans, student loans, etc. The total debt under TDS should amount to under 44% of your gross annual household income. The ratio is at the discretion of the bank/lender/insurer.
Does Mortgage Stress Test help first-time buyers?
A mortgage stress test may affect first-time homebuyers more. This test can drive the young buyers out of the real estate market as they may not pass the stringent test of the big banks/lenders.
This is because first-time buyers usually come with a smaller down payment as they do not carry the benefit of equity from the previous house. They rely on small savings they have accumulated in their small career or gathered from their parents.
The fallout of a smaller down payment is a bigger mortgage, and they need more to qualify against a higher interest rate. Stress test becomes challenging for this buyer group.
