Canada’s banking regulator has proposed changes that would strengthen the stress test applied to uninsured mortgages.
The Office of the Superintendent of Financial Institutions (OSFI) unveiled its proposed changes on Thursday April 8th, which would require borrowers applying for uninsured mortgages—typically those with more than a 20% down payment—to qualify at their mortgage contract rate plus two percentage points or 5.25%, whichever is higher.
The stress test currently has a minimum qualifying rate of 4.79%, nearly 50 basis points lower.
Additionally, OSFI said it plans to “revisit the calibration of the qualifying rate at least once a year to ensure it remains appropriate for the risks in the environment.”
OSFI Superintendent Jeremy Rudin said the higher floor rate is based on an average of the qualifying rate in the preceding 12 months leading up to the pandemic, adding that financial markets must be prepared for a return to pre-pandemic conditions—i.e., higher interest rates.
“The main thing we have to be ready for is an increase in mortgage rates to the pre-pandemic range,” he told reporters. “We have interest rates that are extraordinarily low, even by recent standards.”
He added that the regulator is concerned about market conditions, which elicited this warning to lenders in OSFI’s statement: “OSFI will be looking for heightened vigilance from FRFI lenders in applying the principles of Guideline B-20 related to collateral management, income verification and debt servicing, combined Mortgage-HELOC loan plans and risk governance.”
“Rather than waiting to see any kind of deterioration in underwriting practices, we’re proactively out there reminding lenders that even in these conditions, the principles that we elucidated in B-20 are very important and that we’re going to be looking closely to see that they’re being respected,” Rudin said.
Reaction to the Proposed Changes
Reaction to OSFI’s announcement was swift, with some saying the increased minimum stress test went too far, while others said it didn’t go far enough.
“Increasing the qualifying rate by another almost 50 basis points will only serve to disqualify more aspiring middle-class Canadians and would-be first-time buyers,” Paul Taylor, President and CEO of Mortgage Professionals Canada told CMT. “While 46 basis points isn’t a tremendous difference, philosophically, we’re continuing with a structure that exacerbates the wealth gap and makes it even more difficult for those without a bank of mom and dad to rely upon to own a home.”
It’s estimated that this proposal would reduce purchasing power for uninsured borrowers by between 4% and 4.5%.
“The maximum amount that can be borrowed under the new rule would decrease by 4.5% (from $442K to $422K for a median-income household),” National Bank economists wrote. In comparison, they noted that the B-20 stress test implemented in January 2019 requiring homebuyers to qualify at the higher of either the 5-year posted rate or the contractual rate plus 200 basis points reduced purchasing power by 22%.
“Though the new measure is a step in the right direction for financial stability, we doubt this alone will significantly cool the housing market,” they wrote.
Still, some see the increase in the stress test’s floor rate as overreach, considering it is already about 300 basis points above some of the lowest uninsured mortgage rates still available today (and even more so for variable rates).
“I am struggling to see how this can be justified as a prudential regulatory measure. Prior to today, the hurdle rate used in the stress test was already far in excess of any credible scenarios for future market interest rates,” Will Dunning, MPC’s Chief Economist told CMT.
“As I commented recently, official data from the Bank of Canada shows that the highest actual average lending rate seen since the start of 2013 is 3.76%. This seems to me to be a reasonable interest rate to use in pursuit of prudent regulation.”
Dunning added that the stress test fails to take into consideration two key factors that will reduce the impacts of higher rates at the time of future mortgage renewals: “Repayment of mortgage principal will be more rapid than is implicitly assumed by the stress tests; secondly, borrowers will experience income growth.”
There’s no word yet if changes to the insured mortgage stress test will be forthcoming as well. But the Minister of Finance, who oversees the stress test applied to insured mortgages, said this: “We will continue to monitor housing market conditions across the country. To inform potential steps the government may take, we will closely examine the results of the consultation announced by the Superintendent of Financial Institutions.”
The public is invited to provide feedback to OSFI via B.email@example.com, which will be accepted up to May 7, 2021. OSFI will then communicate some of that feedback and any final amendments to the qualifying rate by May 24, 2021, prior to the new stress test taking effect on June 1, 2021.
What is a mortgage stress test?
A mortgage stress test is conducted by your mortgage lender to see if you are able to keep up with your mortgage payments should interest rates increase. All federally-regulated lenders are required to conduct a stress test, and the stress test is done when you apply for a new mortgage, switch lenders, or refinance your mortgage.
The mortgage stress test will reduce the amount that you are eligible to borrow compared to current rates, or may even disqualify you from a mortgage with a bank or credit union. Your ability to afford mortgage payments is compared against the Bank of Canada’s Five-Year Benchmark Rate, known as the qualifying rate.
How is the stress test calculated?
A stress test is calculated by finding out what your mortgage payments would be if interest rates rise to a value called the qualifying rate. This qualifying rate differs depending on whether your mortgage is insured or uninsured.
If your mortgage is uninsured, then the stress test will be calculated at a qualifying rate which is the higher of
- the Bank of Canada five-year benchmark rate, currently at 4.79%, or
- your current interest rate plus 2%.
If your mortgage is insured, then the qualifying rate is the higher of
- the Bank of Canada five-year benchmark rate, currently at 4.79%, or
- your current interest rate.
When is a mortgage stress test done?
A mortgage stress test is done when you apply for a new mortgage with a federally-regulated lender. It is also done anytime you switch lenders or when you refinance your mortgage. A mortgage stress test is not done when you are renewing your mortgage with the same lender.
Mortgage Stress Test Flowchart
How To Avoid The Mortgage Stress Test
Failing a mortgage stress test means that you will be ineligible for a mortgage at any federally-regulated lender. This includes all of the Big Banks in Canada, including RBC and TD.
If you have failed the mortgage stress test, or you are looking to avoid it, you may consider un-regulated lenders, such as private mortgage lenders. Private lenders are not required to conduct a stress test and they are generally more flexible in their lending requirements, such as if you have a bad credit score or if you are self-employed. However, private mortgages come with much higher mortgage rates, even in excess of 10%.
Switching lenders or refinancing your mortgage also means that you will have to undergo another mortgage stress test. Staying at the same lender means that you can avoid the stress test, but it might mean that you can miss out on better mortgage rate offers at other lenders.
Is a Mortgage Stress Test Needed?
|Same Lender Renewal||No|
Mortgage Stress Test Breakdown
Debt Service Ratios (GDS/TDS) and Mortgage Affordability
Click here for the CMHC Debt Service Calculator
Click here for the CMHC Affordability Calculator
Your mortgage affordability is based on your down payment, GDS ratio, and TDS ratio.
Your Gross Debt Service (GDS) Ratio is the percentage of your housing costs compared to your monthly income. Housing costs include your mortgage payment, property taxes, and condo fees, depending on your property.
Your Total Debt Service (TDS) Ratio is the percentage of your housing costs plus other debts that you may have, such as credit card balances or car loans and student loans, compared to your monthly income.
The Canada Mortgage and Housing Corporation introduced changes that would be implemented on July 1, 2020 for new insured mortgages. A minimum credit score of 680 would be required to qualify for CMHC insurance, as well as a GDS ratio of 35% and TDS ratio of 42%.
The CMHC also will not accept non-traditional sources for your down payment that increase your level of debt, such as if you took out a personal loan for your down payment.
You can use a mortgage stress test calculator to see if you can pass the stress test by estimating your current GDS and TDS ratios, as well as seeing whether your down payment meets the minimum requirements.
CMHC Insurance Requirements
|Minimum Credit Score||680|
|Minimum Down Payment||5%|
What is the current stress test rate?
Currently as of January 2021, the stress test is tested at a rate of 4.79%. This is the lowest it has ever been since the stress test was first implemented in 2018.
The 5-year conventional mortgage rate is the average of the weekly posted interest rates for a five-year mortgage by Canada’s six major chartered banks. This rate is updated every week on Wednesday.
How is the Stress Test Rate calculated?
The stress test rate, also known as the qualifying rate or the Bank of Canada’s five-year benchmark rate, is based on the posted five-year fixed mortgage rates from Canada’s Six Big Banks, including RBC, TD, Scotiabank, BMO, and CIBC. This rate is updated weekly.
There has been criticism towards the use of posted mortgage rates, as posted rates are often kept artificially high in order to inflate prepayment penalties. Proposed mortgage stress test changes would have altered the qualifying rate to be the actual rate that new mortgages are set at instead of the posted rate before any discounts, however these changes have been delayed.
As of January 2021, the benchmark rate for both insured and uninsured mortgages is the five-year conventional mortgage benchmark rate, which is currently 4.79%.
How Does the Mortgage Stress Test Rate Affect Me?
If the stress test rate increases, the amount that you can borrow will decrease. For example, consider a $500,000 home with a 5% down payment, with your annual income being $90,000 with no expenses or other debt. At the current qualifying rate of 4.79%, you will pass the stress test.
However, if the qualifying rate increases to 5.34%, then you will fail the stress test. Even a qualifying rate of 5.19% will disqualify you from a mortgage.
The qualifying rate can change rapidly and it can quickly disrupt your financial plans. The qualifying rate was last at 5.19% in July 2019, and yet fell to 4.79% in August 2020. This means that in the scenario above, you would not have qualified for a mortgage in 2019, but you would have qualified in 2020.
Even so, rates can swiftly move against you. Keeping an appropriate cushion can help you avoid unexpected surprises should rates change.
Since the rate used is either the greater of the Bank of Canada’s qualifying rate or your current mortgage rate, this means that negotiating a discounted rate from your mortgage lender will not help you pass the stress test.
Mortgage Stress Test History
When did the mortgage stress test start?
The mortgage stress test was created in 2017 by the Office of the Superintendent of Financial Institutions (OSFI) with it being implemented starting in January 1, 2018 for all mortgage applicants. The stress test has been applied for insured mortgages since 2016. The stress test was initially only for insured mortgages with a down payment less than 20%. Later changes made it so that the stress test applied to all mortgage applications, for both insured and uninsured mortgages, and no matter the amount of your down payment.
Stress Test Mortgage Rate Changes
|October 25, 2017||4.99%||–|
|January 17, 2018||5.14%||+0.15%|
|May 9, 2018||5.34%||+0.20%|
|July 10, 2019||5.19%||-0.15%|
|March 18, 2020||5.04%||-0.15%|
|May 20, 2020||4.94%||-0.10%|
|August 12, 2020||4.79%||-0.15%|
Source: Bank of Canada