Confused About The Mortgage Stress Test? Here’s How It Works
Since 2018, all home buyers in Canada have been subject to a mandatory mortgage stress test. This applies to everyone hoping to get a mortgage, no matter what your down payment might be. Many Canadians find the stress test strict and confusing. Others have difficulty understanding what it actually is. Keep reading to learn more about the stress test, why it is mandatory, and how it affects you.
What Is The Mortgage Stress Test?
Contrary to what its name may suggest, the mortgage stress test doesn’t measure how stressed out you feel buying a home.
In general, a “stress test” is typically performed to determine whether or not something is financially plausible. A hypothetical decision is stress-tested to figure out whether it can or cannot survive a worst-case scenario.
A mortgage stress test is conducted to determine whether or not a homeowner can handle an unexpected increase in expenses if interest rates were to rise. Whether or not you “pass” or “fail” the test is based on factors including how high your income is, how low your debt is, and whether or not you could pay a higher mortgage rate than what you’ve been offered.
Another way to look at a stress test is that it is a set of rules that determine whether or not you can realistically sustain a particular mortgage.
How Does It Work?
When you apply for a mortgage, your mortgage broker determines a rate at which you will pay back the mortgage. A stress test, meanwhile, measures whether or not you would be able to pay your mortgage if the interest rate were higher. Here’s how this hypothetical higher price is determined.
If your down payment is 20% or higher, your minimum qualifying rate is based on whichever of these percentages is higher:
- Bank of Canada’s five-year rate (This rate is currently 4.79%, but it changes frequently. Check the Bank of Canada’s website for up-to-date information.)
- Your contracted rate plus 2%
If your down payment is lower than 20%, your minimum qualifying rate is based on whichever of these percentages is higher:
- Bank of Canada’s five-year rate
- Your contracted rate
Does It Only Apply To First-Time Buyers?
The mortgage stress test does not just apply to first-time buyers. If you are renewing your mortgage, you must pass the stress test. Don’t worry – it is fairly uncommon for someone to have been able to afford a mortgage, and then fail the stress test years later.
Still Confused? Here’s An Example
Let’s say you make a 20% down payment on a property in Ottawa that costs $480,500. With a 20-year amortization and a five-year plan, you score an interest rate of 2.09%. That means you’ll pay $1,959 per month on your mortgage.
What if your interest rate jumped up to 4.09%? You would now have to pay $2,431 per month — nearly $500 more than what you initially agreed upon. That’s why you take the stress test: to consider whether or not you could make higher payments.
Here’s How The Stress Test’s Rate Is Determined
Let’s say you make a 20% down payment on a property. You score an interest rate of 2.44%. To determine your “stress test rate,” add 2%.
In this example, adding 2% puts your interest rate at 4.44%… so far. Now consider the Bank of Canada’s five-year rate: 4.79%. To pass the stress test, you must be able to pay whichever amount is higher – in this case, your interest rate at 4.79%.
Though the stress test became mandatory for all mortgages in Canada in 2018, the rules surrounding the process have changed. These are the current rules from CMHC:
- You can spend up to 35% (previously 39%) of your gross income on housing expenses.
- You can borrow up to 42% (previously 44%) of gross income, after including other loans.
- At least one borrower must have a credit score of 680 or higher (previously 600).
- Your down payment must come from your own resources (previously, you could use unsecured personal loans, unsecured lines of credit, or a credit card).
Here are two rules from the other two insurers that differ from CMHC:
- You can spend up to 39% of your gross income on housing expenses.
- You can borrow up to 44% of gross income, after including other loans.
- At least one borrower must have a credit score of 600 or higher.
- Your down payment must come from your own resources, or unsecured personal loans, unsecured lines of credit, or a credit card.
What If I Fail The Stress Test?
According to federal law, you must pass the stress test to qualify for a mortgage. If you qualify for a mortgage rate, but cannot pass the stress test, you may have to look for a less expensive property or find a lower mortgage rate. Otherwise, you can talk to your mortgage broker about other potential solutions.
Tips To Help Ensure You Pass
A mortgage broker can help prepare you for the stress test, and answer questions you may have. On your own, you can prepare for the stress test by:
- Crunching Numbers. Calculate as many relevant variables as possible, including your gross income and credit score.
- Pay Off Debt. Since your debt-to-income ratio will affect your ability to qualify for a mortgage, pay off as much debt as you can.
- Practice Budgeting. Find out on your own if you could live under the mortgage payments you’d be required to make. If you can’t make it work, you may not pass the stress test.
Can You Avoid The Stress Test?
Yes! If you have more than 20% down payment, there is a way to avoid the stress test. While federally regulated institutions must abide by the stress test, provincially regulated institutions do not. For example, credit unions are generally provincially regulated, and they do not need to abide by the stress test. Most of them choose to abide by federal policy, but there are some who can qualify based on contract rate. This is a great alternative, and as a broker, we always look at this option to see if there is a way to have a borrower qualify for financing.
How A Mortgage Broker Can Help
A mortgage broker cannot override the rules of the stress test, but they can help get you the best mortgage you can afford. They will connect you with lenders and make the process of getting a mortgage easier and faster.
The stress test might make it seem like a wrench has been thrown into your plans to get a mortgage, but it is a useful metric to determine whether or not you could handle a hypothetical payment increase. By understanding the stress test and working closely with a mortgage broker, you should be able to secure the best mortgage possible, even under the seemingly strict rules of the stress test.
Chris Allard’s experience in the field means he can get you offers with over 50 financial institutions lending in Ottawa. Every lender has many mortgage products they offer, which means Chris and his team will make sure a mortgage caters to your needs while also ensuring you get a competitive rate. Chris Allard is a proud mortgage broker of Smart Debt Mortgages, independently owned and operated. Smart Debt broker #12236.