We’ve seen what lax lending standards can do to borrowers, lenders, and the housing market as a whole. Borrowers who overleverage themselves can find themselves in financial hot water when interest rates go up, leaving them sometimes unable to keep up with their increased mortgage payments as a result. Plus, the increasing household debt in Canada can thin out Canadian bank accounts and make it more difficult to keep up with bill payments.
In an effort to curb this situation, the mortgage stress test was introduced in order to make sure mortgage applicants are able to make their mortgage payments even in the event that mortgage rates rise. But this obviously made it tougher for Canadians to get approved, especially for higher mortgage amounts.
But as of early spring 2020, borrowers may have more borrowing power as changes to the mortgage stress test are coming.
What Is The Mortgage Stress Test?
The purpose of a mortgage stress test is to protect both lenders and borrowers from defaulting on their home loans should there be an increase in interest rates in the near future. If that happens, some borrowers may be financially incapable of contributing to higher mortgage payments as a result. In turn, this could increase the likelihood of defaulting on their mortgages, which would place both lenders and borrowers in peril.
The mortgage stress test was established as a way to prevent such unfortunate situations from happening if rates increase. The test was created by the Office of the Superintendent of Financial Institutions to deal with the high level of Canadian household debt but was originally applicable only to mortgages with less than a 20% down payment that were subject to mortgage default insurance. It has been applicable to insured borrowers since October 2016, after which the stress test for uninsured mortgages took effect in January 2018.
What Are The New Changes?
Under the current mortgage stress test, borrowers must qualify at the interest rate offered by their lender plus 2%, or the current Bank of Canada five-year benchmark (which is currently 5.19%) plus 2%, whichever is greater. Under the new stress test requirements, borrowers with mortgages that are subject to mortgage default insurance must qualify at 2% over the rate offered by their lender or 2% over the new weekly median 5-year fixed insured mortgage rate based on home loan insurance applications.
This means that borrowers must have an income high enough and debt low enough to be able to make mortgage payments if rates increase. As such, the loan amount that can be borrowed would be lower based on today’s stress test requirements versus if there was no stress test required at all.
Right now, the 5-year fixed-rate is 2.89%. That would mean that borrowers would need to qualify at 4.89% (2.89% plus 2%). Based on these changes, it will be slightly easier for borrowers to qualify for a mortgage. The difference in interest rates between the current requirements of the stress test and the new requirements will make a big difference in mortgage qualification. The rates that lenders offer for insured mortgages are usually a lot lower than big banks’ posted rates.
As mentioned, these changes apply to those with mortgages that have less than a 20% down payment and are insured either by CMHC insurance or private insurers in Canada. The changes are slated to take effect on April 6, 2020. That said, it is expected that the new changes will be applicable to uninsured mortgages too at some point in the future.
Borrowers will essentially be able to qualify for higher loan amounts based on the new stress test rules. A borrower applying for a mortgage at a rate of 2.89% plus 2% and tested using the new standard would qualify for a higher-priced home purchase compared to the way the stress test stands right now.
To illustrate, the difference in rates would mean that a borrower with a household income of $100,000 and a 10% down payment with a 5-year fixed-rate mortgage would be able to qualify for a home worth $526,632 versus a home worth $511,424 under current stress test rules, according to calculations from RateHub. That’s a difference of over $15,000, which shows that borrowing power is increased thanks to the new rules that will soon take effect.
Why Are Changes Being Made To The Stress Test?
There has been widespread criticism that the gap between the requirements of the current stress test and quoted mortgage rates is far too big and expanding more and more every day as rates continue to hover near historic lows. As such, the current stress test was reviewed late in 2019 in an effort to better represent actual market conditions and the rates offered by lenders.
How Will The New Change Affect Canadians?
The new change will make it easier for Canadians to secure a mortgage, and will also make it easier to get approved for higher loan amounts. That means that borrowers will be in a better position to purchase a more expensive house than they would had these changes not come about, as can be seen through the illustration above.
This is especially important given the skyrocketing prices in certain centres, including Toronto and Vancouver where home prices average $828,000 and $1.29 million right now, respectively.
That said, some suggest that the ease of obtaining mortgages might drive prices even further, considering the higher borrowing power that Canadians will have. This may foster a higher demand for housing, which can further send home prices up. And an increase in demand will also eat up more of the already-tight inventory.
It’s been tough for many Canadians to break into the housing market, especially after the mortgage stress test came into effect for both insured and uninsured mortgages. But the proposed changes that will take effect in the spring will help ease this burden and help make homebuying more affordable for many.
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