Thousands of Canadians are optimistic of owning their own home someday. They are hard at work, saving their money, building up a deposit, and finally applying for a mortgage. But the mortgage market has been entirely changed in recent years by the implementation of a mortgage stress test. The stress test is designed to safeguard homeowners and mortgage applicants, to ensure that in the future they can pay off their mortgages, and this guide will introduce you to what you need to know about how it works and what it does.
What Exactly Is A Stress Test?
For those who have little experience in the financial sector, the word ‘stress test’ may seem a little confusing, but it’s quite a common phrase among banks and other financial institutions. A stress test is essentially a method for forecasting a worst-case scenario, which can be applied to a variety of different financial conditions. The stress test takes account of the fact that interest rates which rise by the time the mortgage term of a borrower is up for renewal when it comes to mortgages. It is in order to ensure that the borrower will be able to maintain its mortgage payment in the event that, upon renewal, the rate rises dramatically to avoid potential mortgage default, missed payments or sales power in the event that payments become unmanageable.
Why Do We Need Stress Tests?
In the minds of many, stress checks can appear pointless, but they are actually very useful and are intended to protect ordinary individuals who want to make use of financial resources such as loans and mortgages. They help you find out whether or not you can afford to pay off the money you’re borrowing, even though there’s a tragedy. It can be very useful and comforting to know in advance that you will be able to pay off your loans or mortgages, both for you and for the bank or lender giving you the money in the first place. Stress tests can help minimize defaults, debts, and financial drama in short.
So, What About The Mortgage Stress Test?
In 2017, the Canadian mortgage stress test was formally adopted. Since then, if they want to get a mortgage from an A lender at AAA rates, any prospective homebuyer searching for a mortgage, regardless of whether it is an uninsured or high-ratio mortgage, and homeowner looking to refinance their current mortgage, has had to undergo the stress test. The mortgage stress test was implemented at a crucial moment to help Canadians see whether or not they will be able to handle potentially higher mortgage payments in the future, because interest rates have been so low in recent times and are destined to go up in the years to come.
How Does The Stress Test Work?
The stress test can be broken down as follows: the bank can give you an interest rate if you apply for a mortgage through a bank, which is often measured based on your credit score and income to debt ratio. However, the bank will then measure your mortgage qualifying at a much higher rate for the purposes of the stress test, essentially creating a ‘worst-case scenario’ for you as a borrower, and then checking to see whether you will be able to handle the payments at that high rate, while your real rate would be much lower.
Either of two possible rates may be used by the bank: the Bank of Canada’s five-year rate or the rate produced by the bank plus 2 percent. The one used for the stress test would be whichever rate is higher. So, for example, if you are applying for a mortgage and the bank gives you a 1.79 percent rate, they can either use the 5-year rate of the Bank of Canada, which is 4.79 percent in this case as of the date this article is published. In that case, the stress test rate will be 5.19 percent, determined by adding 2 percent to your recommended rate of 3.19 percent for the purposes of the stress test, as the stress test is based on the greater of 4.79 percent or 2 percent applied to your actual contract rate. Let’s presume the rate you are offered is 3.19 percent. However, some lenders may allow you to circumvent the stress-test rule and allow you to use the contract rate as the stress test rate, such as some credit unions and trust companies. The rate for this is usually higher, however.
As of the date of publication of this report, DUCA Credit Union has the lowest non-stress test rate of 2.54 percent. So even though it’s higher than a 1.59 percent bank rate, you will be able to apply for a much higher mortgage sum with 2.54 percent as the qualifying rate rather than the 4.79 percent stress test rate that will allow you to actually get a mortgage rate as low as 1.59 percent. So, between decreased monthly payments or a higher mortgage amount, it just depends on what you want.
Example of the Mortgage Stress Test
Let’s look at a specific example.
Let’s say that you and your wife are either looking to purchase a new home or refinance your current property and want to know what the maximum amount of mortgage you will apply for is.
Let’s also assume that you and your spouse’s total annual household income is $120,000.
Let’s also assume that you and your spouse have no current debts.
Scenario #1:
Interest rate: 1.59% (Stress Test Mandatory)
Annual Property Taxes: $5,000
Qualifying Rate: 4.79% (Stress-Test Rate)
Maximum Mortgage Amount Qualified For: $523,869
Monthly Payment for a mortgage of $523,869 amortized over 25 years at 1.59% interest: $2,116.06 per month
Scenario #2:
Interest rate: 2.54% (No Stress Test Needed)
Annual Property Taxes: $5,000
Qualifying Rate: 2.54% (No Stress Test)
Maximum Mortgage Amount Qualified For: $751,918
Monthly Mortgage Payment for $751,918 amortized over 25 years at 2.54% interest: $3,383.35 per month
As we can see, although the interest rate is higher by 0.95%, you would be able to qualify for a mortgage loan of $751,918 instead of only $523,869. That’s an additional $228,049 in mortgage that you would be able to get in this example. It’s important to note that the difference in monthly mortgage payment between an interest rate of 1.59% and 2.54%on a $751,918 mortgage amortized over 25 years is 346.13 per month. That’s right! If you were to qualify for a $751,918 in mortgage amount at an interest rate of 1.59%, your monthly mortgage payment would be $3,037.22 per month instead of $3,383.35 per month at an interest rate of 2.54%.
How Do I Pass The Stress Test?
And how does the bank really find out what you can afford and whether or not the worst-case scenario described in the stress test could be coped with?
Well, they make use of two main variables. Gross debt service ratio, or GDS, is the first of these variables, which is actually the amount of your income that would go towards housing expenses such as heating costs, condo fees, property taxes, and mortgage repayments. The second factor is the overall debt service ratio, the TDS, which is determined by adding loans, credit cards, etc. to your existing debts and adding income taxes, heating costs, condo fees, and mortgage payments to your property.
To apply for a loan, you need to have a GDS of 32 percent or less and a TDS of 40 percent or less in certain instances. They can see that you should have enough discretionary income, even taking into account loans and bills, to pay for your mortgage if you can meet these criteria. Bear in mind that the banks will use the stress test qualifying interest rate for your stress test qualifying rate, which will be greater than the rate that you would actually have to pay.
What Are The Effects Of The Stress Test?
For a good cause, the stress test was done which will help discourage individuals from going into debt that they would not be able to pay back, potentially finding themselves in very frightening financial circumstances. Since the stress test was adopted, however, there have been some negative side effects. First-time buyers, who will now find it even harder to get approved for a mortgage to purchase their first home, are one of the major problems.
First-time buyers would have been able to apply for greater mortgages before the test was implemented and thus had a broader range of possible properties to choose from. The overall value of your mortgage as a first-time purchaser is decreased with the new rules. The stress test has obviously made it harder for many potential buyers to break into the market, with a competitive housing market in many areas of Canada.
Can I Get Around The Mortgage Stress Test?
The mortgage stress test has been a legal requirement for Schedule 1 banks since its inception, so when applying for a mortgage at a bank, there is not really any way to bypass it or get around it. The laws have to be followed by all major banks and the vast majority of lenders do the same. So you’ll actually have to go through the stress test if you’re applying for a mortgage, unless you deal with a mortgage broker who has access to many lenders who are willing to circumvent the stress test and in many cases still provide you with great low interest rates. By saving a larger down payment, decreasing your debts, and finding a house within your means, you will improve your odds of being successful in passing the stress test.
Get in touch with a Maxium Maurice Dsouza – Mortgage Broker today by email at info@maxiumdsouza.ca or call at 437-353-9977 to directly speak to him.