The OSFI Mortgage stress test is used by mortgage providers to evaluate your long-term financial profile. From a financial perspective, a stress test is just how it sounds. It’s a way of testing if you can afford to pay your mortgage if rates were to increase or if you experienced a sudden bout of financial turmoil. The test may also restrict the amount you may borrow in contrast to current rates. Or even, disqualify you from a bank mortgage.
Simply put, the Canadian mortgage stress test forces you to come face-to-face with the very high costs of being a homeowner. So, how do you pass?
What Is The Purpose Of The Stress Test?
The stress test was designed by the Office of the Superintendent of Financial Institutions Canada (OSFI). It is intended for potential homeowners who are borrowing through federally regulated lenders, such as banks. The test, however, may not apply to provincially regulated credit unions, private mortgage lenders, or b-lenders. The stress test aims to prevent consumers from getting themselves into unmanageable debt by taking on a mortgage that’s too big for them.
The test is intended for all potential and current homeowners. Including homeowners with a mortgage term of fewer than 5 years. And those applying for conventional uninsured mortgages (more than a 20% down payment).
Only those who are renewing their mortgage with the same lender, are exempt from the stress test. That means, if you switch lenders when renewing your mortgage, you’ll still have to undergo a stress test.
Is Household Debt In Canada A Problem?
The average Canadian household has a debt load of 180%. Meaning, that for every $1 earned, $1.80 is owed. Plus, with high interest rates, many would-be homeowners may not be able to afford their houses in the years to come.
Your mortgage lender and the OSFI have to consider debt to get a clear picture of your finances now, and 5 years from now.
Mortgage Stress Test Terms You Should Know
To better understand the mortgage stress test you’ll have to familiarize yourself with some terminology.
Here are four terms to know:
- Interest Rate – An interest rate refers to the cost associated with borrowing.
- Benchmark Rate – Canada’s benchmark (5.25 %) rate is what lenders are required to use to qualify mortgage borrowers in Canada.
- Qualifying Rate – A projected rate calculated by your lender. Used to determine if you can afford payments at a higher rate.
- Contractual Rate – This is the official rate that your monthly payments are based on for a mortgage. It’s the rate you and your mortgage provider agree to in your mortgage contract.
How Is The Canadian Mortgage Stress Test Calculated?
The mortgage stress test is calculated by determining if qualify for your mortgage using the minimum qualifying rate, which is:
- The higher of 5.25% or the contractual mortgage rate plus 2%.
For instance, if a borrower has a contractual mortgage rate of 3%. The lender will use the 5.25% since it’s higher than the contractual mortgage rate (3%) plus 2%. Similarly, if you qualify for a 4.5% mortgage rate, you’ll need to qualify using a rate of 6.5% (4.5% + 2%). Since it’s greater than the benchmark rate (5.25%). This formula applies to all insured mortgages (down payments of less than 20%) and uninsured mortgages (down payments of 20% or more).
How Much Can I Afford To Borrow For My Mortgage?
The stress test, beyond your capability to handle your mortgage under rising interest rates, will take into account your debt profile. Your Gross Debt Service (GDS) and your Total Debt Service (TDS) ratio are both crucial parts of determining your mortgage affordability.
- GDS – Percentage of your income allocated to monthly house expenses (mortgage/rent, utilities, property taxes). Should be less than 39% of your monthly income.
- TDS – Percentage of your income allocated to all debts including homeowner expenses and other debts (credit cards, student loans, and car payments). Should be less than 44% of your monthly income.
Example Of An Affordable Mortgage
Now, let’s say you live in Ontario with an annual household income of $200,000. Monthly expenses of $3,652. Plus you have $60,000 for a down payment and were offered a 7.25% mortgage rate on a 25-year mortgage with a 5-year term.
How much mortgage would you realistically be able to afford?
According to the CMHC mortgage affordability calculator. You should be able to qualify for a home valued up to $527,651.
However, this might be a good time to consider if you will be able to afford the mortgage in the coming years.
How To Stress Test Your Mortgage
Applying for a mortgage is no easy feat, so it may help to stress test yourself to see what areas you may need to work on. Here is how to test yourself and ensure your likelihood of passing.
How Much Do You Have Saved For A Down Payment?
Regardless of whether you have enough to make a 20% down payment, you will need to undergo the stress test when working with a federally regulated lender. But, knowing exactly how much you have to put toward your down payment will help you determine how large of a mortgage you can afford.
Determine What Interest Rate A Bank Will Offer You
If you’re in the beginning stages of purchasing a house, you can get pre-approved with your bank. This way you’ll have an idea of what interest rate you can qualify for.
Determine The Monthly Mortgage Payment You Can Afford
Next, you need to figure out how large of a monthly mortgage you can afford right now. Armed with your down payment amount and interest rate, a good mortgage calculator can help you figure this out.
Can You Afford Your Mortgage Payments If Interest Rates Rise?
The mortgage stress test will determine how much you can afford if interest rates rise. To test this, you’ll need to check if you can afford your mortgage with an interest rate of 5.25% or your contractual mortgage rate plus 2%, whichever is higher.
You can use a mortgage calculator to figure out what your monthly mortgage payments would be at this new higher rate. Ask yourself if you would comfortably be able to afford it.
Gross Debt Service Ratio (GDS)
Your GDS represents how much of your gross income goes toward all housing costs. Your lender will include all monthly house expenses such as condo fees (if applicable), mortgage payments, heat, and property taxes.
All of these costs will be added together and divided by your gross monthly income. Ideally, lenders want to see a percentage of no more than 39%.
Total Debt Service Ratio (TDS)
All your debt will need to be factored into the equation as well. This represents how much of your monthly income is used to cover your debt. Debt includes car payments, loans/student loans, credit cards, lines of credit, etc. When all of these are added up, your TDS should be no more than 44% of your gross monthly pay in order to get approved.
How To Prepare For the Mortgage Stress Test
There’s not much that can be done about the benchmark rate and the rate that your lender is charging you, but it would help to have a basic understanding. Ideally, you should chat with a mortgage advisor, mortgage broker or real estate agent.
- Pay Down Your Debt – Your lender will look at all the debt that you currently carry and factor it into whether or not you’re eligible for a mortgage. The smaller your current debt load, the lower your TDS will be, which may help improve your chances of getting approved.
- Apply For A Smaller Loan amount – Be realistic about how much house you can actually afford. Not only will this increase your odds of passing the stress test. But it can also free up more of your income and prevent you from becoming house-poor.
Crunch Some Numbers – Ask yourself if you could really afford to pay an additional $500-$1K, for example, in mortgage payments if rates suddenly increase after you’ve been approved.
Can I Avoid The Stress Test?
The stress test is designed for federally regulated banks. However, private/alternative lenders or lenders regulated on the provincial level, and credit unions are not under OSFI’s jurisdiction. As such, lenders like these are not required to put their mortgage applicants through these stress tests the way traditional banks and other federally regulated lenders must.
So, if you’re one of those prospective homeowners, alternative subprime lending might be a viable option for you. However, it’s important to be aware that the interest rates most alternative lenders charge are higher than those of a traditional lender. So, while you might qualify more easily with a non-traditional lender. It’s good to keep these issues in mind before you apply with one, as it could end up costing you more down the line.
Considering An Alternative Lender?
If you’re having trouble getting approved for a mortgage from a traditional financial institution or you’re interested in avoiding the stress test, you may want to consider choosing an alternative lender. Loans Canada can help match you with a licensed mortgage specialist who can best meet your needs.