Mortgage stress test appears to be one of the most difficult for Canadians, especially after a recent update. But despite the difficulties, here are some tips on how to pass it well.
There is hardly a person in the world who has never been afraid of a mortgage. Everyone knows that a loan not only entails a change in lifestyle and additional obligations but also that you have to make a serious effort to obtain it. It takes a long time to prepare for a loan — saving for an initial deposit and working on credit history can take years. As if these factors were not enough, there’s another challenge — the widely known loan stress test.
It was launched in 2018. Under the new rules, a Canadian resident who wishes to apply for a loan from a federally regulated moneylender must pass the OSFI stress test. The purpose of this test is to check a potential lender’s level of financial stability — would he be able to continue making required payments if the percentage rate increases. A candidate’s financial capabilities are examined very closely. Only if the test result is positive, he will be approved for the mortgage.
In this article, we will look at exactly what kind of fruit the mortgage stress test Canada is and learn how you can overcome it without much difficulty. We will look at the rule updates that were introduced in 2021.
Mortgage stress test explained in detail
There is probably hardly a financial institution in the world that would be willing to lend money to a prospective homeowner without a guarantee. This stress test is a kind of necessary check that serves as a guarantee to the money lenders. This test looks at how the potential homeowner would react to sudden stressful situations — would his financial situation be stable enough to withstand the unexpected increase in borrowing rate due to fluctuations in the market? Would he default on payments in the event of a relative’s illness or a sudden job loss? The test is passed if the prospective homeowner demonstrates that he meets the lender’s minimum requirements, or in other words, that he is within the established “qualified rate.”
Mortgage Stress Test Updates in 2021
Beginning June 1, 2021, the prospective homeowner must demonstrate the ability to pay in the event of an interest rate increase of up to 2% or 5.25%. For example, you plan to take out a loan with a borrowing rate of 5.04%. Under the test, you must prove and demonstrate that you would not lose your financial stability if the interest rate increased to 7.4% (5.04% + 2%). The moneylender would assess your financial capabilities as if it had to borrow at a percentage rate of 7.4%.
The regulations that went into effect in 2021 have complicated the situation for homebuyers in several ways. First, the situation became more difficult for homeowners seeking to refinance. Second, the new rules reduced the buying power of most homebuyers by nearly 20%.
Affect that this test has on people in Canada
The stress test assumes two types of qualification rates. The bank calculates the affordability of the loan to the applicant based on the interest rate he would receive. For example, if he wants to apply for a loan with an interest rate of 3.25% or less, he must pass a test that assumes he has taken out a mortgage at 5.25%. If a potential consumer wants to apply for a loan with a higher borrowing rate than 3.25%, he must take the test with the interest rate set by his moneylender plus 2%.
Example from life
Suppose your family lives in Ontario and has an annual income of one hundred thousand dollars. You plan to make an initial deposit of $50,000. You are approved for a loan with a borrowing rate of 2.5% for 5 years, repaid over 25 years. What mortgage amount can you afford?
The loan affordability calculator (developed by CMHC) shows that you would be able to consider buying a home the price of which is no higher than $637,329. The borrowing rate used for the calculations is 5.25%.
Important Note: To simplify the calculations, household expenses have not been included.
Why was the stress test implemented?
All at once the amount of debt issued in Canada became very high. The reason for this was the imprudent actions of citizens who took out mortgages that they eventually could not repay. The explanation is simple – home prices and percentage rates are rising every year. Right now, according to statistics, the average Ontario family is 170% in debt on their annual income.
In an effort to get a handle on the problem and prevent citizens from getting into even more debt, government structures took certain measures in 2016. Among these measures was the introduction of this test.
Initially, the test was only for people who qualified for mortgages with high percentage rates or loans with a period of less than 5 years. In 2018, a new regulation was introduced – even those who qualified for a conventional mortgage had to undergo a test.
Changes in rates since 2016
|Qualifying rate for uninsured mortgages
|Qualifying rate for insured mortgages
|March 17, 2020
|5.25% or the established rate for the mortgage + 2%
|5.25% or the established rate for the mortgage + 2%
|May 19, 2020
|4.79% or the established rate for the mortgage
|4.79% or the established rate for the mortgage + 2%
|August 11, 2020
|4.94% or the established rate for the mortgage
|4.94% or the established rate for the mortgage + 2%
|June 1, 2021
|5.04% or the established rate for the mortgage
|5.04% or the established rate for the mortgage + 2%
How do you undergo a mortgage stress test?
Before applying for the check, make sure you meet all the conditions listed.
1. Determine the amount of initial deposit required
Since 2018, a potential homebuyer must pass the test even if they make an initial contribution of less than 20%. It is important that you know the amount that should be saved for a first deposit. Knowing this number will help you determine the amount of mortgage you can afford.
2. Investigate what percentage rate you could be offered
The interest rate should be clarified at the very beginning of negotiations with the lender, as this figure has a significant impact on the total amount of the loan
3. Clarify the amount of the regular payments
Use the mortgage calculator to determine the amount of affordable regular payments.
4. Make sure you can afford to increase the interest rate by up to 2% or even 5.25%
Calculate how much you would have to pay each month if the borrowing percentage increased. Ask yourself if the new amount would be affordable for you.
Unfortunately, there is almost nothing you can do to change the terms set by the government. You can not lower the interest rates set by the moneylender. What you can do is prepare well before you apply for a mortgage.
Start by getting your finances in order. A good choice would be to consult a financial advisor to learn about your options to pass the test successfully.
There are some criteria that lenders use to review a borrower’s ability to pass the test. Here is a list of those criteria:
- Gross Debt Service (GDS). This ratio is the percentage of your pre-tax income that you need to cover all of your household expenses. Your monthly loan payments, water and electric bills, property taxes are combined and divided by your monthly income (excluding taxes). The perfect number for lenders is a percentage of less than thirty-two percent.
- Total Debt Service (TDS). This ratio indicates how much income you need per month to pay off your debts, including personal loans, car loans, education loans, etc. The figure that is appropriate for creditors is less than forty-two percent of your monthly income (excluding taxes).
- Make a realistic request. You probably had your eye on that gorgeous house that cost $900,000. Instead of tightening your belt, you might be better off considering more affordable options. A smaller loan amount may make it easier for you to pass an audit.
- Do some calculations. Determine the amount of potential additional expenses that would be affordable for you. Assess your financial situation – would an extra $750 payment bankrupt you? What would happen to you if your percentage unexpectedly increased due to a crisis in the market? This last question is especially important for those applying for an adjustable-rate mortgage.
Is it possible to avoid passing the mortgage stress test?
The only way to avoid scrutiny is to apply to a financial institution that is not regulated by the state. There are some banks in the country that are not regulated by OSFI. The disadvantage of this situation is that these banks usually charge a higher percentage rate than traditional banks. Also, thanks to the recent housing regulations, alternative banks can set higher rates for their services.
Keep in mind that even if the application process is easier with alternative banks, you could be saddled with additional costs.
What will happen in the future?
The most recent updates were introduced not too long ago, but OSFI has already received many complaints. Due to the high set standards, the purchasing power of many Canadians has dropped significantly. As a result, OSFI is facing increasing pressure to lower the standards.
The introduction of the rules was decided for a good reason — to slow down the growth of the real estate market and thus slow down the rapid increase in prices in the real estate market.
Right now, the situation in the market is unclear — the amount of debt issued in Canada has become very high. People are taking out loans for houses they can not afford — the unexpected rise in housing prices is shaking their financial situation and they are stopping their regular payments.
The situation will not resolve itself — certain steps need to be taken by the government structures. However, the tightening of mortgage testing rules, which were introduced to rectify the situation, has led to discontent among the people.
Moreover, the new rules have led to a cooling of the market, which in turn has led to an increase in interest rates. This consequence led the OSFI to the idea of reconsidering the established rules.
However, the OSFI has not yet made a final decision or indicated its intention to relax the rules. Would there be any changes or not — only time will tell.
Mortgage Stress Test FAQ
- What do I need to successfully pass through a check?
You must prove to the moneylender that a sudden increase in the percentage rate will not shake your financial condition and that you will not stop making payments on your loan. The moneylender draws its conclusions by examining your TDS and GDS ratios under the percentage rate. If your scores are higher than the set bar – then you will fail the test.
- How much do you need to earn to afford a house worth $500 000?
You can do the necessary calculations using the loan affordability calculator. In this case, you would need to put up an initial contribution of more than 20% and have an annual income of more than $75,000. The loan you should apply for should have a percentage rate of 2.5% for a five-year period and be repaid over 25 years.
- Is there any way to avoid passing a test?
You can bypass the tests by applying for a loan from a bank that is not regulated by OSFI. But be prepared for higher percentage rates.
A couple of final thoughts
The OSFI test is not easy to pass, especially considering the recent rule changes. It is advisable to consult a financial advisor and get your finances in order before applying. If you fail the test, try to find an alternative lender that is not subject to OSFI regulations.