For prospective homebuyers, there are several financial hoops to jump through on the way to property ownership: growing a healthy down payment, securing a preapproval, and finding a home that fits within budget, to name a few. Yet, even with years of financial planning, the dream of homeownership can quickly come crashing down if one cannot jump through the hoop that trips up first-time and repeat buyers alike: the mortgage stress test.
In January 2018, the Office of the Superintendent of Financial Institutions, a federal watchdog and the sole regulator of Canadian banks, implemented the Residential Mortgage Underwriting Practices and Procedures guideline — otherwise known as B-20. Under B-20, all new and renewing homebuyers who opt for a regulated mortgage lender are subject to a mortgage stress test, which evaluates the borrower’s ability to afford residential mortgage payments against higher interest rates. OSFI says that this policy protects Canadian homeowners from excessive debt and unaffordable mortgage payments.
The stress test, which is one component of our B-20 guideline, is a safety buffer that ensures a borrower does not stretch their borrowing capacity to its maximum, leaving no room to absorb unforeseen events. Borrowers across Canada face different risks that could impair their ability to pay their mortgage: changes to income, changes to expenses, changes to interest rates.
However, the mortgage stress test does not affect everyone equally. In Canada’s most expensive markets, such as Toronto, where the average price of a home is expected to surpass $820,000 in 2019 (https://www.livabl.com/2019/02/toronto-home-prices-2017-highs.html) , buyers have been disqualified for mortgages by the test based on high down payment requirements. Meanwhile, in cheaper real estate markets, such as Regina, the real estate prices fell in the third quarter of 2018. Yet, as the job market remains stagnant in some cities, meeting the income standards to pass the stress test creates a provincial disadvantage.
The one downside is that it’s made it harder for some buyers to get into the market because what they can spend on a home now is a lot lower than what it was a year or two ago before the stress test.
In other cases, desperate buyers are opting to avoid the stress test altogether by choosing to work with private lenders, who are not federally regulated by OSFI and offer much higher interest rates. Some have questioned the financial stability of the market with this increased presence of higher interest rate lenders.
People are going to private lenders, and that brings on other risks, It brings on economic risks because if people are paying $4,000 a month for a private lender mortgage payment, they can’t go to restaurants, they can’t buy clothes, they can’t spend money on other things.
If you’re a first-time buyer, don’t stress about the stress test.
What does the stress test do?
All Canadian buyers are required to take the mortgage stress test, but how you are tested depends on the size of your down payment.
If you have a down-payment of less than 20 percent of the home purchase price, your mortgage is automatically insured. With the added insurance premiums, your payment rates are increased up to 4 percent higher. Insured mortgages will be tested between the interest rate offered by the regulated mortgage lender — typically, one of the top five banks of Canada — against the Bank of Canada’s conventional five-year mortgage rate (5.34 percent as of February 2019).
Those with uninsured mortgages and down payments greater than 20 percent, will be have their current rate tested, plus a two percent point increase, against the five-year bank rate. To pass the stress test, the calculated interest rate must meet the Bank of Canada’s qualifying rate or the contracted rate plus two percentage points, whichever is higher. For example, if your lender offers an interest rate of 2.99 percent for your uninsured mortgage, plus two percentage points, your calculated interest rate would need to meet the Bank of Canada’s minimum qualifying rate of 5.34 percent, since it is the greater of the two.
The mortgage stress test will consider elements such as your gross income, debt and expenses. A mortgage qualifier calculator (https://mccapp.ca/app/jamie-lazar) can give you an idea how much income and down payment amount you’ll need to pass, but speaking with a mortgage broker before you begin the process is always your best option.
In the past, you could just go on some mortgage calculator and try to estimate yourself. But with stress tests and all of these new mortgage rules, you want to go to a mortgage broker for them to tell you, in theory, what you qualify for, because that really sets your expectation of what you can afford to spend on a home.
Does it matter if I choose a variable or fixed-rate mortgage?
If you wish to secure a fixed-rate mortgage, the stress test may dash those hopes.
Fixed-rate mortgages are typically priced higher than variable-rate mortgages, as variable-rate payments fluctuate with interest rates and a higher proportion of a mortgage payment goes to principal. These higher fixed-rates can limit your options when applied to the stress test. Borrowers looking at a fixed-rate of 3.69 percent with an uninsured mortgage, plus two percentage points, wouldn’t qualify against the Bank of Canada’s rate.
There are some clients who are so tight they can’t have a 5.69 [percent] stress test, they need a 5.34 [percent] stress test, so they have to get the variable rate even if they want fixed. If you make a lot of money you can have both options, but if you have a very tight file, you might only have the option of variable.
I want to change mortgage lenders. Will I have to retake the stress test?
A common criticism of the stress test is its tendency to trap borrowers with their current lenders. Buyers who purchased their home prior to the stress test are still required to participate. For those who won’t pass, it means staying with the same mortgage lender to avoid disqualification.
Imagine that you want to renew your mortgage but you technically don’t qualify under the new stress test. You’re technically handcuffed with that same lender, they can charge you eight percent interest and you can’t do anything about it.
While OSFI ensures that the stress test, contributes to public confidence in the Canadian financial system. We have to question whether this element of the policy benefits the market overall.
If the bank knows the borrower cannot leave, how competitive are they going to be with their rates? Some of my lowest interest rates are when their mortgage is expiring and I can move them to a new lender. But if they don’t pass the stress test, they’re basically forced to stay with their current lender, which doesn’t make sense.
Can I avoid the stress test?
If you’re a nervous test taker and want to sit out, then you do have the choice to not take the stress test — but at a cost.
The mortgage stress test does not apply to unregulated mortgage finances companies, called MFCs. While provincially regulated, these lenders operate in the private market, which makes loan approvals easier to obtain, but at higher rates. I suggest that an MFC lender should be reserved for short-term loan options.
If you’re a first time buyer dying to buy a place and you go to a private lender, I don’t necessarily know if that’s the right solution. I think private lenders are meant for very short term solutions, to help someone in a very specific situation, and then to get out of that situation ideally in 12 months or less.
MFCs tend to take on riskier borrowers, so higher interest rates compensate for that liability. But these higher payments, could push new buyers into being house poor.
It’s meant to be a stop gap, it’s not meant to be a long-term, sustainable way to borrow money, because it’s very expensive.
What happens if I fail the stress test?
Flunking the stress test is not the end — you can always retry later with a higher down payment or increased income. The Bank of Mom and Dad could be available for some buyers looking for a mortgage co-signer or a boost in down payment funds.
While there has been increasing pressure for OSFI to provide policy relief for those in expensive markets, they remain firm on preventing “relaxed mortgage underwriting standards. There is always future potential for first-time buyer relief, but overall, exceptions to a national policy are unlikely to be made for individual market conditions.
Being an election year we could see some relief in the coming months such as a pull back on the stress test, possibly a full basis point and whispers of increased amortization from 25 to 30 years on insured mortgages are being heard in Ottawa.
NOTE: Next Bank of Canada meeting is March 6th, 2019