Applying and taking out a mortgage is the most substantial financial commitment for many Canadians. In fact, buying a home is the largest purchase most people make in their lifetime. But as prime rates and inflation continue to skyrocket, this commitment comes with a lot of risk. However, the Canadian mortgage stress test attempts to mitigate this risk. This lending threshold serves as a safeguard against affordability challenges stemming from increasing rates in Canada.
Table of contents
- What is a mortgage stress test in Canada?
- What is the current mortgage stress test in Canada?
- How do you pass the stress test for a mortgage?
- Is Canada’s mortgage stress test still relevant?
Whether you’re a current homeowner looking to refinance or you plan to purchase your first property in the coming years, it’s best to understand the Canadian mortgage stress test, as it’s one of the most important standards governing mortgages. But you may wonder, what the Canadian mortgage stress test entails, how and when are borrowers stress tested, and what are the criteria for passing a stress test. This article covers everything you need to know. Continue reading to find out more!
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What is a mortgage stress test in Canada?
While the 2008 Global Financial Crisis is not a direct causative for the institution of the Canada mortgage stress test, the test is a ripple effect of that economic event. The United States implemented their own stress test for mortgages and many countries followed suit, including Canada.
The Global Financial Crises revealed to the world the frail nature of the financial world and the risk of lax lending. In response to this, Canada tightened their reins on lending policies. Thus the introduction to the mortgage stress test.
This action was done to ensure candidates can keep up with future rises in interest rates in cases of the unforeseen in the economy. In other words, a mortgage stress test seeks to examine a potential borrower and ensure that the individual can still keep up with any increase in interest. This applies to borrowers applying for variable or fixed rate mortgages, but rises in interest affect variable interest rate borrowers the most.
When was the mortgage stress test started in Canada?
In 2016, the stress test was first introduced to borrowers. It applied to those who plan to make down payments ranging between 5% and 19% and who were also required to purchase mortgage default insurance. Essentially, the Canada mortgage stress test was introduced in 2016 to protect:
- Lenders: The stress test helps lending institutes ensure their potential borrowers can keep up with higher interest if a rate hike were to occur. This helps reduce the risk of losses, loan delinquencies, and the resulting crash of such companies.
- Borrowers: The Canada mortgage stress test helps a potential borrower to know their strength and ability to maintain stability if and when a spike occurs.
- Housing Market: The stress test helps maintain stability in the housing market overall. This was achieved by preventing excessive borrowing. Or lending to those who may not be able to weather sudden economic changes.
The Canada mortgage stress test has many benefits to different people in various sectors of society. It was introduced as a way to regulate the housing market in Canada.
Who introduced the new mortgage stress test in Canada?
Between the months that ran through 2016 and 2017, there was a recorded increase in the cost of homes. This led the federal Canadian government to design and implement the Canada mortgage stress test. More specifically, the Office of the Superintendent of Financial Institutions (OSFI) introduced and manages the stress test. There wasn’t any specific individual who introduced the legislation, but rather a general response from the government to rising housing prices.
Although, over the years, stress tests evolved from 2016 to 2018. These evolutions brought new requirements for buyers to meet to be a qualifier. As a result, it became more challenging for Canadians to “pass” the stress test. This will be discussed further in the sections below.
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What is the current mortgage stress test in Canada?
In 2016, the Office of the Superintendent of Financial Institutions (OSFI) introduced the Canada mortgage stress test to help buttress the economy against future failure. OSFI is Canada’s core federal financial regulator. Their duties include:
- Risk Assessments
- Consumer Protection
- Supervision of Financial Bodies
- Provision of Guidance for Financial Institutions
The Office of the Superintendent of Financial Institutions was launched on the 2nd of July 1987. Their roles were properly defined in the year 1996 after the Office of the Superintendent of Financial Institution Act was passed. This law is what defines the duty and jurisdictions of OSFI. It also provides legal power to carry out nationwide financial institutions.
What are the new stress test rules in Canada?
As already stated, the stress test has evolved over the years. Currently, the Canada mortgage stress test requires that borrowers qualify at:
- The Bank of Canada’s Five-Year Mortgage Rate: This is an estimate of the mortgage rates available to potential borrowers. It plays a major role in the stress test. This is because individual borrowers must qualify by meeting the percentage benchmark. As of October 2023, the rate is at 5.25%. This is against 5.58% as of last year and the older 8.06%. The borrower is expected to hit the benchmark, or above it, to qualify for a mortgage. This negates whether or not the borrower acquired a loan with a lower interest rate. This benchmark rate is there to assess the strength of the borrower. Thus, saving the borrower’s stress and lender’s loss.
- The Contract Rate Plus 2.0 Percentage Points: This is another key component for the stress test. If a borrower gets a loan with a 3.0% rate, for example, the 2.0% policy comes into play. The idea is to forecast a borrower’s ability to weather an interest rate hike. The contract rate in itself tends to vary from borrower to borrower and amongst lenders and is quite negotiable.
Borrowers are required to meet one of the above criteria, not both, and whichever is higher is considered. These are the current criteria implemented as of June 1, 2021. To date, there haven’t been any updates to the Canada mortgage stress test.
How does the new stress rule affect potential borrowers?
The stress rule was first introduced to take the tension out of the housing market by keeping borrowers from taking on more debts than they could handle. Many Canadians were rapidly entering the housing market to take advantage of rising prices and access equity quickly, regardless of whether they could afford it. Although, the amendment made it harder than ever before to get a loan. In some ways, it placed more stress on an already stressed market.
While this is neutral, or even protective in itself, it may have a seemingly negative impact on potentials. This is because the new stress test puts a tighter rein on borrowing, reducing the chances of getting a home by 20%. This means that individuals with lesser income are very unlikely to get a chance at purchasing a home than they did before the stress test was amended.
Everyone taking a mortgage from an OSFI-supervised lender is subject to this test. This includes those with insured mortgages regardless of who the lender is. While borrowers renewing their mortgages are not required to take the stress test, new home buyers would find themselves tied to it. This can be very disheartening and frustrating. If you need help with your mortgage application and going through the stress test, a financial advisor can help.
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How do you pass the stress test for a mortgage?
The Canada mortgage stress test is, well, stressful! So how do you raise your odds of approval? Keep reading to learn some tips and tricks.
What is the Solution?
The new stress rules have made it quite hard for average income earners to get a good loan for housing. However, there are basic solutions to this. The amount to be borrowed will drastically reduce if the potential borrower makes a heavier down payment. Essentially, the more money deposited as a down payment, the lesser the amount needed to borrow. In turn, this means lesser interest to be paid and an easier ability to pass the stress test. Here are a few ways to cushion the new stress test rules:
One good way to start working towards buying a house would be to start saving for a larger down payment. It is advisable to seek out a tax-free savings account and a tax-free first home savings account. These allow Canadians to save without having to pay taxes on investment income or withdrawals. Another way would be to save in a high-interest savings account.
If the buyer can increase their annual earnings, they are very likely to make a better down payment and, thus, beat the stress test formidably. In addition, higher income always makes it easier to qualify for a loan of any type.
Home Buyers’ Plan (HBP)
With a Home Buyers’ Plan, a borrower can get loans of up to $35,000 from your Registered Retirement Savings Plan (RRSP). In other words, you can access savings tied up in a RRSP without penalty to put towards a down payment. This plan is only for first-time home buyers, is tax-free, and comes with a 15-year repayment period. It does require that you are a permanent resident or a citizen of Canada. You are also required to move in within a year as your main home base.
Private Mortgage Lenders
Private loan companies tend to be less stringent on mortgage demands. They would even give out loans to borrowers with poor credit scores. The downside is that they charge a much bigger interest rate that might make you want to stick to government-affiliated ones. The stress test is there for a reason, even if it is challenging to pass!
If you renew your mortgage with the same lender, you will not be required to go through the test again. However, it might mean missing out on better contracts.
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How is the Mortgage Stress Test Calculated
You must pass one of the following criteria to meet the Canada mortgage stress test. The higher value of the two is considered. The calculation varies based on the lender you’re working with. It’s advisable to meet with multiple mortgage brokers and lenders to increase your odds of approval. The two criteria are as follows:
- The contract rate: This is the interest rate charged by whatever company that gives you the loan. It is negotiable.
- The qualifying rate: This is the interest rate that you should be able to afford in case your contract rate is increased. It doesn’t necessarily mean you will pay for that, it’s just a measure against taking more than you handle.
To pass the mortgage stress test, for both insured (under 20% down payment) and uninsured mortgages (over 20% down payment), it is expected that the borrower meets the qualifying “five-year mortgage rate” and an added 2% to the contract rate.
Is Canada’s mortgage stress test still relevant?
The change in time and the current disaster of the world’s economy has led to many questioning the relevance of this mortgage stress test. Why keep it if it does very little good? Of course, there are a variety of debates as to whether or not the mortgage stress test is still of any use to Canadian citizens. Some feel it was once useful, but has become obsolete.
There are those like Matt Albinati who believe that the stress test has lost its relevance in today’s society. In his own words, “I would say that maybe the stress test applying 2% above what current rates are is exceeding what the risks are. I am all for building a buffer for people’s financial situation, but the stress test limits the amount people can borrow.“
The head of staff at OSFI, Peter Routledge, thinks the system has become imperfect or rather, incomplete. According to him, the OSFI will be amended as it is done annually. Still, people like Frances Hinojosa, the CEO of Tribe Financial, believe that the stress test should be left as it is, at least till the world leaves its current economic storm. This way, people will not over-leverage themselves on mortgages. OSFI is currently reviewing the stress test. News is expected to come by the end of 2023. In other words, the stress test, after it has been reviewed, is expected to resume its place of relevance.
Does the Canada mortgage stress test have your head swimming? If so, a financial advisor can help you with your application and the process of passing the stress test. Complete this quick questionnaire to be matched with one today!