Are you in the process of buying a house? Whether it’s your first purchase or your fourth, you’ll need to undergo a stress test to secure a mortgage.
In Canada, financial institutions use this test to assess your ability to manage loan repayments if interest rates rise. This precaution helps protect both banks and borrowers from potential financial difficulties due to interest rate fluctuations.
If you are considering getting a mortgage, it’s essential to understand the details of the stress test. Let’s dive in!
What is the purpose of the mortgage stress test?
The mortgage stress test acts as a crisis simulation to assess borrowers’ ability to make mortgage payments if interest rates increase. Since rates can change multiple times a year, this assessment is essential, especially for those with variable-rate loans.
To qualify for a mortgage, buyers must demonstrate that they can handle higher monthly payments should interest rates rise. This process reduces the risk of default for lenders and helps ensure that homeowners won't face an immediate financial strain if rates do go up.
Essentially, the stress test evaluates the borrower’s finances under worst-case scenarios compared to their current situation, helping to prevent excessive debt in the pursuit of homeownership. If a borrower fails the stress test, the lender is not allowed to approve the loan.
Stress test: when and why was it created?
The mortgage stress test was introduced in 2018 by the Office of the Superintendent of Financial Institutions (OSFI), which oversees more than 400 financial institutions across Canada.
This measure was implemented in response to concerns about the rapid growth of the Canadian mortgage market, which posed risks to the country’s economic stability. Ensuring that borrowers can reliably repay their loans became a priority.
Since its introduction, the stress test had undergone some adjustments, particularly regarding its qualifying rate, but it remains an important requirement for obtaining a mortgage in Canada.
Who must undergo the stress test?
Initially, the stress test only applied to borrowers with down payments of less than 20%, specifically those obtaining high-ratio mortgages.
However, under the new mortgage rules, all buyers are required to undergo the stress test. This includes those making a minimum down payment, as well as those putting down more than 20% or seeking to renew or refinance their existing mortgage with a new lender.
That said, borrowers may be exempt from the stress test if they are working with private lenders.
Do mortgage renewals require a stress test?
Up until now, the mortgage stress test could apply to borrowers looking to renew or refinance their existing mortgage with a new lender. However, this will change as of November 21, 2024.
Starting on that date, homeowners with an uninsured mortgage will be able to switch financial institutions without needing to pass the stress test again, making it easier to change lenders during renewal.
Currently, only borrowers with insured mortgages are exempt from the stress test when switching lenders.
How is the stress test calculated?
To assess a borrower’s financial capacity, the stress test uses a qualifying rate, which is the higher of the Bank of Canada’s key interest rate or your mortgage interest rate plus 2%.
For example:
- The Bank of Canada's key interest rate: 5.25%
- Your mortgage interest rate: 3.75% + 2%
Calculation:
-
3.75% + 2% = 5.75%
In this case, since your mortgage adjusted rate of 5.75% is higher than the Bank of Canada’s key interest rate, it will be used for the stress test.
To calculate your borrowing capacity and eligibility for a mortgage, financial institutions also use two ratios: the Gross Debt Service (GDS) and the Total Debt Service (TDS).
What are the consequences for buyers?
The stress test directly affects buyers borrowing capacity, making it more challenging to obtain a mortgage. By evaluating financial capacity at a higher interest rate, the test lowers the amount you qualify for, as it assumes a greater portion of your income will go towards debt repayment. As a result, you have less money available to purchase a property.
This effect is often more pronounced for first-time buyers, who typically have fewer assets and smaller down payments, making the home-buying process more complex.
However, it's important to remember that the primary goal of the stress test is to protect buyers by ensuring they don’t take on a mortgage beyond their repayment ability. This helps prevent over-indebtedness among Canadian homeowners.
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