A mortgage is the biggest financial commitment many Canadians will make in their lifetime. And while a mortgage is a huge responsibility, it can also mean freedom, security, and independence.
But a mortgage is a loan, and to make sure it doesn’t become an overwhelming financial burden, the government implemented measures in place to ensure current and potential homeowners don’t take on more debt than they can handle.
Enter the mortgage stress test. If you’re looking to buy a house or are coming up on mortgage renewal time, chances are you’ve heard of the stress test, and may have questions about what it is and whether you have to take it.
Today, we’ll tell you everything you need to know about the stress test, including how it works, how to prepare for it, and steps you can take to increase your chances of passing.
Important update for insured mortgages
As of March 16, 2020, due to the Bank of Canada’s emergency inter-meeting rate cut of 50 bps due to COVID-19 concerns, the change of the stress test rate planned for April 6, 2020 that would have made it easier for insured mortgages to pass has been suspended indefinitely. The planned change was to reduce the minimum qualifying rate for insured mortgages.
New (easier to pass)
The bank must use the higher interest rate of either:
- the interest rate you negotiate with your lender
- weekly median 5-year fixed insured mortgage rate from mortgage insurance applications, plus 2%.
With the goal of making the rate more representative of the mortgage rates offered by lenders and more responsive to market conditions.
What is the mortgage stress test?
The mortgage stress test was implemented by the Office of the Superintendent of Financial Institutions Canada (OSFI) on January 1, 2018 to help ensure that all homeowners with high-ratio or uninsured mortgages are to afford their mortgage payments in the event their financial circumstances worsen or interest rates increase. This means mortgages are harder to qualify for, but it also provides security for homeowners.
For example, say you and your partner are a dual-income family with some residual student loans and a baby on the way. Right now, you’re both gainfully employed and making well over $100,000 a year between the two of you. At the moment, you might have no trouble getting approved for a $400,000 mortgage with an interest rate of 2.69%, and you’d be able to make the payments comfortably.
However, what happens in 9 months when the baby comes and one of you goes on parental leave, and possibly decides to stay home permanently with the kid. Or, what if interest rates spike, or one of you loses your job? Would you still be able to comfortably make your mortgage payments?
The mortgage stress test is designed to ensure that if your financial circumstances change tomorrow, you’ll still be able to afford the home you bought today.
How does the stress test work?
When you apply for the mortgage, the lender or broker will go through the normal application process, and hopefully qualify you for a mortgage of a certain size at a specific interest rate.
Let’s use the same numbers from the previous example and say the bank qualified you for a $400,000 mortgage, you negotiated down to an interest rate of 2.69%, on a 5-year fixed term, and an amortization of 25 years. Your monthly payments would be $1,829.93.
To pass the stress test, you’d have to qualify for the same mortgage, but with a higher interest rate. There are two rates considered for the stress test, and you have to qualify for whichever is higher in order to be approved.
Insured mortgage stress test example
Let’s assume that your down payment was less than 20%, so the mortgage will be insured. The bank must use the higher interest rate of either:
- the interest rate you negotiate with your lender (2.69%)
- the Bank of Canada’s conventional five-year mortgage rate (eg. 5.1%)
The Bank of Canada qualifying rate changes weekly. Let’s say it is 5.1%. That’s higher than 4.69%, so to pass the stress test, you’d have to qualify for the $400,000 mortgage with an interest rate of 5.1%, and monthly payments of $2,349.24.
Uninsured mortgage stress test example
Let’s assume that your down payment was greater than 20%, so the mortgage will be uninsured. The bank must use the higher interest rate of either:
- the interest rate you negotiate with your lender (3.3%) plus 2% = 5.3%
- the Bank of Canada’s conventional five-year mortgage rate (eg. 5.1%)
Therefore, to pass the mortgage stress test, you have to qualify for the $400,000 mortgage at an interest rate of 5.3%. With the same terms, that would mean monthly payments of $2,395.20.
What numbers are important for passing the stress test?
Passing the stress test is a numbers game, and there are a few crucial calculations lenders will look at when qualifying you. The two most important numbers are your total debt service ratio (TDS) and your gross debt service ratio (GDS).
Total debt service ratio
Your TDS is the portion of your monthly income that’s required to cover all your debts. To figure this out, start by adding together all your monthly debts, including:
- Property taxes
- Heating costs
- Student loans
- Car payments
- Lines of credit
- Personal loans
- Other debts and financial obligations
Then, take that total and divide it by your gross annual income. To pass the stress test and get approved for a mortgage, your TDS shouldn’t be higher than 42%.
Gross debt service ratio
GDS is similar to TDS, but it looks at the portion of your income that’s needed to cover your housing costs specifically. To calculate your GDS, add up all your monthly housing costs, including mortgage, heat and utility bills, condo fees, interest, and taxes.
Divide that total by your gross annual income. To be approved, your GDS shouldn’t be higher than 35%.
Do I have to take the stress test?
The stress test applies to any Canadian who’s applying for a mortgage or switching lenders at mortgage renewal time. This includes both high-ratio and conventional mortgages. However, only federally regulated lenders are required to administer the stress test, and that includes:
- Trust companies
- Monoline lenders
- Loan companies
In other words, you’ll have to pass the mortgage stress test if you’re: A) applying for your first mortgage or switching your mortgage to a different lender, and B) using a conventional lender like a bank.
Can I avoid the stress test?
There are indeed ways you can avoid having to pass the stress test. One option for current homeowners is to stick with the same lender. When your mortgage matures, you can bypass the stress test by renewing your mortgage with the original lender, rather than switching.
For new mortgages, you can avoid the stress test by applying for a mortgage through an unregulated lender, which includes:
- Credit unions
- Private mortgage lenders
- Mortgage Finance Companies
The trade off with unregulated lenders, however, is they usually charge a higher interest rate. Therefore, you might be able to bypass the stress test, but your monthly payments will be higher and your mortgage will cost more in the long run.
What can I do to make sure I pass?
When you apply for a mortgage, the two key numbers a mortgage professional will look at are your TDS and GDS. If these percentages are too high — meaning your housing expenses and total debts account for too much of your income — chances are you won’t get approved for the mortgage or won’t pass the stress test. There are some things you can do to help pass the stress test and get approved, and they are:
- Come up with a larger down payment
- Pay a lump sum on your current mortgage (for homeowners who are switching lenders)
- Decrease your home-buying budget and look for a more affordable house
- Cancel any loan applications that are in process
- Pay off credit card, personal, student, car, and other loans
- Increase your annual income
- Find a co-signer for the mortgage
The mortgage stress test has made it more difficult for Canadians to get approved for mortgages. At the same time, the rule is protecting homebuyers and homeowners from incurring too much debt, especially when housing prices continue to rise.
Moreover, passing the stress test will afford you peace of mind, because you’ll know you can still afford your house even if your financial situation changes.
You’ll have to pass the stress test if you’re applying for a mortgage or switching lenders, but there are a few ways you can avoid the test. If you’re worried, there are calculators out there you can use to give yourself a better idea of your financial standing, and steps you can take to give yourself a better chance of passing the test.
What’s a high-ratio (insured) mortgage?
When people talk about a high-ratio mortgage, it means the buyer didn’t have a full 20% down payment. Typically, you can get a mortgage with a down payment as low as 5%. When a mortgage covers 81 to 95% of the purchase price of the house, this is a high-ratio mortgage. In Canada, high-ratio mortgages must be insured through Genworth Financial, Canada Mortgage and Housing Corporation (CMHC), or Canada Guaranty.
What’s a conventional (uninsured) mortgage?
A conventional mortgage is one where the buyer had a down payment of 20% or more. These mortgages don’t require insurance.
What’s a monoline lender?
Monoline lenders are financial institutions that only provide one product or service, such as mortgages. In Canada, monoline lenders for mortgages include:
- Canadiana Financial
- Street Capital
- First National
- Merix Financial
- Mortgage Qualifier Tool – Financial Consumer Agency of Canada
- Calculating GDS/TDS – Canadian Mortgage and Housing Corporation
Over to you
Are you stressing out over the mortgage stress test? Have you passed it recently and have tips for other Canadian homebuyers and homeowners? Share your story or advice in the comments below.