What is a Mortgage Stress Test?
A mortgage stress test is exactly how it sounds. In finance, a “stress test” is a way of evaluating the worst-case scenario for any investment. When it comes to mortgages, it’s used to determine the risks associated with a loan application. For example, a stress test would consider questions like:
- With your current debt-to-income ratio, how much can you afford?
- If the interest rates were to increase, would you be able to make the monthly mortgage payments?
- If you were to lose your job, what is your backup plan to manage these payments?
Its purpose is to promote responsible homeownership, and does so by factoring affordability directly into the mortgage application process. What it comes down to, is making sure home buyers have the financial bandwidth to withstand interest rate hikes. It tells lenders whether or not you’re able to afford your mortgage payments if an increase were to happen.
How does the Mortgage Stress Test work?
For Canadians who are looking to secure, renew, or refinance a mortgage, you’ll have to pass the mortgage stress test. So, whether you’re a first-time home buyer or a homeowner with a mortgage that’s up for renewal, when applying for a mortgage you need to meet the “minimum qualifying rate”. In other words, you have to prove you can afford the greater of two options, either:
- The contracted rate offered by your lender, plus 2%; or
- The Bank of Canada’s benchmark five-year mortgage rate (currently at 5.34%, as of August 2018).
This applies to all home buyers, both:
- New applicants, regardless of down payment size; and
- Current borrowers who, at the end of their mortgage term, plan on switching lenders.
Basically, a mortgage stress test evaluates whether or not, you’d be able to service your loan under pressure.
What does the Mortgage Stress Test mean for Home Buyers?
The stress test has a direct effect on your purchasing power; it significantly reduces the amount you can borrow for a mortgage. Told another way, take what you thought you could afford and bring that number down. For many prospective buyers, you either need to come up with a larger down payment or buy a less expensive property. Because of this, many home buyers are having to turn to several different sources to fund the house they want.
Specifically, buyers who are house hunting at their maximum budgeted price points, and who spend a substantial amount of their gross income on housing expenses are most at risk of feeling the impact.
Fact is, the net result of the mortgage stress test is that it’s forcing many home buyers away from the free hold market and into the condo market. All of this comes down to affordability. And, it’s this artificial increased demand into the condo market that has caused Toronto condo prices to spike this year.
Why Should you Care About the Mortgage Stress Test?
If you’re thinking, does this really affect me? Well, according to a recent report released by the Mortgage Professionals of Canada, these strict mortgage rules are leaving 18% of home buyers out of the market. While the mortgage stress test is supposed to protect the Canadian housing market (and ensure borrowers are spending within their means), reality is, home buyers are having to work with a lower budget. This means:
- Finding a smaller house;
- Choosing a neighbourhood that’s more affordable (but not your first pick); or
- Holding off on purchasing.
Does this sound familiar? It’s best to work with your mortgage advisor and a realtor you can trust to make sure you can get your dream home.
#AskFM
Whether you’d like more information on the mortgage stress test, or have a question about the Toronto real estate market in general, just #AskFM. Connect with us on social or drop us a line.
