What Is the Mortgage Stress Test?

Getting mortgage loans is not a cakewalk. It has become walking on a tightrope in the present because of the consistent tightening of the qualification rules. A mortgage stress test is a new kid on the block, and if you are planning to get a mortgage loan, understanding it becomes most important. Here is everything you need to know.

Key highlights:

• The monetary crisis of the year 2008 and subsequent amendments by the Canadian government led to the development of the Stress test.
• A stress test aims to improve the quality and the overall process of lending mortgage loans by ensuring that the loans are available to ones who can repay them.
• As of January 2018, the stress test applies to all mortgage loans.
• As of June 2021, the interest rate of a stress test is higher of:
  • 5.25% and 
  • Your contracted mortgage rate plus 2%

What Led to The Development of Mortgage Stress Test?

We all know about the global meltdown of the year 2008. It was a recognized beginning of the recessionary phase when most of the banks either went bust or got considerably weakened. 

This “cash crunch” situation was so severe that the Canadian Federal government and the governments worldwide supported their economy by extending help to their troubled financial institutions.

There are several theories and reasons for such a global crisis, with irresponsible lending being one of them.

“Before the 2008 crisis, getting money was easy for most Canadian homebuyers. I got a mortgage loan without paying even a penny towards the down payment. Even my amortization period was 40 years, and there was not a thing called a stress test, then.”, said Noah Martin, a resident of the Greater Toronto Area who got a mortgage loan in 2007.

Noah was one of the few lucky ones who remained unaffected because of the global crisis of 2008. He did not lose his job and kept meeting his mortgage payments.

But not everybody is Noah, and several homebuyers faltered on their mortgage payments after the 2008 crisis.

It led the federal government to implement a series of measures, rules, and regulations to safeguard the entire financial ecosystem of Canada.

It all started in July 2008 when then conservative finance minister of Canada Jim Flaherty reduced the maximum amortization period from 40 years to 35 years, followed by several other changes in the subsequent years.

Finally, it was in the year 2016 that a stress test aimed to check your:

• Financial prowess
• Loan eligibility and 
• Affordability of high mortgage payments

What Is a Stress Test in The Mortgage Industry?

A mortgage stress test aims to check whether you will meet your monthly mortgage payments on your interest rate hike.

You will be required to pay your mortgage payments only at your contracted interest rate, but this acts as a qualification rule and better assesses your financial capability.

“It puts you in a fictional setting and judges if you can afford to pay those high monthly mortgage payments,” said Chris, a home aspirant searching for condominiums in Brampton, Ontario.

As of January 2018, even if you make a down payment of over 20%, you need to undergo and qualify for a “stress test”.

Now, the stress test applies to all mortgages, and your chances of obtaining a mortgage loan are bleak if you cannot pass your stress test.

How Is Interest Rate Calculated in A Mortgage Stress Test?

The stress test, as the name suggests, puts you under stress by calculating your mortgage interest rate in the following manner:

Higher of:

1. The 5-year benchmark rate as notified by the Central Bank of Canada (5.25% as of June 2021)
2. The mortgage rate at which you have a mortgage loan from your lender plus 2%.

To reduce the default risk and strengthen the Canadian financial markets, the Canadian government implements this “stress test” via:

• The Office of the Superintendent of Financial Institutions (OFSI) and 
• The Minister of Finance

The above authorities review the qualification rates of a stress test annually.

How Does a Mortgage Stress Test Work in The Mortgage Industry?

Let us understand the process of a stress test through a practical example.

• Jacob and Olivia are first-time homebuyers and are looking to buy a condominium in the Greater Toronto Area.
• They have shortlisted a few properties in Milton and Burlington.
• After carefully assessing the asking prices and ready funds available to them, they have taken a mortgage loan of $500,000
• They have approached a few lenders and are getting a mortgage loan at an interest rate of 4% per annum for 20 years.
• Lenders are asking them to undergo a stress test.

A financial institution needs to assess Jacob and Olivia’s affordability via a stress test.

To get a mortgage loan, Jacob and Olivia will be required to prove that they have the financial capacity to pay mortgage payments if you calculate these at a higher rate of 1) and 2):

1. 5.25%
2. 6% (4%+2%)

Jacob and Olivia will make mortgage payments at their contracted rate of 4%, a monthly mortgage payment of $3,030. But they will have to prove that they can afford to pay even a monthly mortgage payment, calculated at 6%, about $3,582.

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