As if getting approved for a mortgage wasn’t challenging enough, the new rules of the mortgage stress test could make it even harder. As of January 1st, 2018, all Canadian buyers who are obtaining a mortgage from a federally-regulated lender, including borrowers who put at least 20% as a down payment – will be put through the OSFI Mortgage Stress Test as basic protocol.
All Canadian lenders will now have to make sure that the conventional home loans they issue are qualified using the Bank of Canada’s 5-year benchmark rate (currently at 4.89%) or at the current contracted rate + 2% – whichever is higher.
The stress test will apply to all new mortgages as well as mortgage renewals for borrowers who are changing financial institutions. This means that the size of the mortgages that Canadian borrowers will be able to qualify for, based on their down payment and income, will effectively be reduced.
While they aren’t required to, lenders have the option to apply the stress test at the time of mortgage renewal for their existing borrowers. Based on these new rules, the approximately 10% of Canadians who obtained uninsured mortgages (meaning they put less than 20% down) between 2016 and 2017 wouldn’t have been able to qualify.
What Exactly is the New Mortgage Stress Test?
The Mortgage Stress Test (MST) is nothing new. It was typically applicable only to insured mortgages, whereby the borrower planned to make less than a 20% down payment. However, as of the new year, all borrowers, even those who have hefty down payments, will be subject to the new stress test.
For more information about high-ratio (insured) mortgages, click here.
Stress tests for mortgages essentially assess the risk of home loans for borrowers. Basically, the stress test will help lenders to determine each borrower’s ability to handle making their monthly mortgage payments in full and on time each month, especially as the interest rate increases.
Borrowers will also be assessed based on their debt-to-income ratio in terms of being able to comfortably afford the mortgages they are being given. The new stress test will essentially help lenders assess how likely a borrower will default on their mortgage.
The term “stress” is used here because the test will help to identify how well borrowers will be able to still pay their mortgages even when placed under added financial stress, such as when interest rates climb. Even a few ticks upward on the interest rate can make a significant change to the cost of the overall mortgage. Borrowers need to be able to prove that should this happen, they’ll still be able to make their payments every month.
Borrowers’ total debt ratio – which is the ratio of total debt and total assets – should not be any more than 44% in order to pass the stress test. In addition, borrowers cannot spend any more than 32% of their income on the cost of housing, including mortgage payments, utilities, and property taxes.
What to know what much a house costs in your city? Check out this infographic.
How Will the Stress Test Affect Borrowers Looking to Refinance in 2018?
There’s no doubt that this new stress test, which all borrowers will be subjected to, will diminish borrowing power. In fact, the test is said to lower borrowing capacity by at least 18.5%, and the bigger the discrepancy between the pre-approved quoted interest rate and the stressed rate will further reduce this capacity.
Borrowing capacity is basically a borrower’s ability to service their mortgage loans provided by their lenders and is highly influenced by the Gross Debt Service (GDS) and Total Debt Service (TDS) ratios. An increase in any one of these ratios will inevitably reduce borrowing capacity.
If you’re looking to refinance your mortgage in the new year, you will have to qualify for your mortgage based on the higher stress-test rates instead of your existing mortgage rate stipulated on your pre-approval contract.
Refinancing your mortgage? Take a look at our Appraisal Checklist.
Let’s say you have a 5-year, fixed-rate mortgage of $100,000 left to pay on a $400,000 home you purchased, with a 3.25% rate. If you’re considering making renovations, you may want to consider refinancing your mortgage to tap into the equity in your home to cover the cost of the work to be done.
Right now, if that amount you need to borrow to pay for the renovation is $100,000, your lender will need to ensure that you can comfortably handle a $200,000 mortgage (original $100,000 mortgage that you have left plus the additional $100,000 needed for the renovations) at the rate of 3.25%.
But as of the 1st of January, your lender will need to make sure that you can handle paying that $200,000 based on 5.25% (3.25% + 2%). If you’re already nearing your borrowing limit, you might not be able to qualify for the entire $100,000 addition to your current mortgage balance.
How the New Rule Could Affect Debt Consolidation Plans
The new stress test rule change could make it a lot tougher for current homeowners who depend on their home equity to consolidate their high-interest debt, including credit cards. While not all lenders will necessarily adopt these new rules right away, some will, and it could start a ripple effect.
For homeowners with a ton of high-interest debt, the urgency to consolidate may be more pressing. If homeowners can’t use the equity in their homes to consolidate their high-interest loans, they may be faced with being bogged down with high interest that stands in the way of whittling down their actual principal.
How to Increase Borrowing Capacity Amidst New Stress Test Rules
The new rules regarding stress tests on borrowers taking out new mortgages or refinancing existing home loans cannot be avoided. But borrowers may still be able to put themselves in a better position and effectively increase their borrowing capacity by lowering their GDS/TDS ratio, which is what impacts borrowing capacity. In order to reduce this number, borrowers may do any one of the following:
- Put a higher down payment towards the purchase of a home
- Increase gross household income
- Pay down debt obligations
- Shop for lower-priced homes
Read this to learn how to perform your own stress test.
Final Thoughts
With the new rules surrounding mortgage stress tests impacting all Canadian borrowers, it’s important to take steps to protect yourself. Be sure to take the time to fully understand how much you can qualify for under the new stress test rules and get pre-approved for a mortgage before searching for a new home. Crunch the numbers based on your household income and speak with an experienced mortgage specialist who will be able to help you work through the numbers to see how the mortgage stress test will impact your affordability.
