What is the stress test for mortgage?
The stress test is a set of rules that the banks and brokers are required to use to determine whether you qualify for a mortgage and what you affordability is.
They essentially “stress test” you at a higher rate than the current interest rate, to lower the risk of a borrower biting off more debt than they can chew.
The assumption is that we are at a historic low for interest rates, and that there is a chance that the rates will increase. When an interest rate rises, your mortgage payments will also increase – so the purpose of the stress test is to make sure you can still afford your payments in the event that the rates rise.
By testing against a higher interest rate, the lender is able to lower the risk of the borrower defaulting on payments. However, as a result of being tested at a higher amount than the actual current rate, the stress test also restricts the buyer’s borrowing power and thus lowers their affordability.
While this previously only applied to high ratio mortgages (less than 20% down), it has seen been changed to include any buyer that is looking to obtain a mortgage on a property. (updated 2019)
How is the stress test calculated?
The stress-test qualifying rate is calculated as the HIGHEST of either rate:
- The Bank of Canada posted five year average rate, which is currently 5.19 as of September 2019. (This is subject to change, it was previously 5.34)
- Two percentage points above the actual mortgage rate
Because they will base the stress test rate on whichever is higher, that means that if your rate is less than 3.19%, that they will take the Bank of Canada posted five year rate (5.19%) to stress test you. (3.19%+2%=5.19%)
If your rate is higher than 3.19%, say 3.5%, then they will take your offered rate of 3.5% + 2% and calculate the stress test based on a rate of 5.5%.
How does the stress test affect my affordability?
The stress test affects your affordability because you have to prove that you can still afford your mortgage payment at a much higher interest rate than what you will actually be charged.
To put this into real terms, if you wanted to borrow $400,000 and the bank is offering you a rate of 3.5%, you would have to prove you can afford a mortgage payment of about $2,440 per month (at 5.5%), even though your actual monthly mortgage payment (at 3.5%) would be just under $2,000.
So, in reality even though you can afford your monthly down payment based on your current income at the current interest rate, if you can’t afford it at the government’s stress tested interest rate then in their eyes you can’t afford it. (and in turn won’t be approved for financing at that amount/price) Because of this stress test, the majority of new homebuyers have had their purchasing power slashed by about 20%. The new stress test rules have also made it more difficult for current homeowners to refinance or renew their mortgage.
On the plus side, as of recent news (updated September 2019), the Bank of Canada lowered their 5 year posted rate from 5.34 to 5.19 – which is the first decrease they’ve made in 3 years. This allows a buyer the opportunity to buy a slightly more expensive home than they would have previously been able to. Working with rough numbers, assuming a borrower had a minimum 20% down payment and no other debts, was a $100,000 a year earner, and had good credit, they would have a $12,000 increase in mortgage affordability with a rate of 5.19 compared to the previous rate of 5.34.
Why was the stress test implemented?
The mortgage stress test is designed to tackle the household debt issue (The average household in Canada is indebted at 170% of their disposable income, which means that Canadians owe $1.70 for every dollar they earn after taxes) and make sure that home purchasers don’t bit off more debt than they can chew.
In addition, the stress test is implemented to avoid defaults on mortgage payments. Because interest rates have been at historic lows that will likely increase down the road, the government implemented the stress test to ensure that borrowers will still be able to afford their mortgage payments when rates eventually do rise.
While you may not be able to qualify for as much of a mortgage as you would have pre-stress test, at least if interest rates do rise the government is protecting you from you stretching yourself too thin, defaulting on your mortgage, and losing your home if you can’t afford higher payments in the future.
Who does the stress test apply to?
All mortgage applicants are now required to undergo this test. Previously it only applied to high ratio mortgages, borrowers that were putting less than 20% down, but now applies to every one that is obtaining a mortgage regardless of how high your down payment is.
This regulation is also applicable to those who wish to change to a different lender when their mortgage expires.
Understanding how much you can afford and what a lender is willing to loan you can be an overwhelming and stressful situation, but with the right team & guidance the process can be much more streamlined. If you’re considering applying for a mortgage, then give us a call. Start a conversation by calling 604-765-0376. Prefer text? 604-319-0200 or email [email protected] to start a conversation. We’re here to help.