It should come as no surprise that in 2019, many Canadians found themselves holding onto large amounts of debt. Statistics Canada reported that in the fourth quarter of 2018, the average household in Canada is indebted at 178.5 per cent of their disposable income. This means that for every dollar the average household earns, they owe $1.785. Adding to this problem is skyrocketing housing prices throughout the country. In response to these macroeconomic issues, the Office of the Superintendent of Financial Institutions (OSFI) decided to alter its guidelines for sound mortgage underwriting or “B-20.”
The 2008 financial crisis highlighted the repercussions of extensive risk-taking by banks on the economy. Changes to the B-20 officially came into effect in Canada in January 2018. The most significant change was the introduction of the mortgage stress test. The stress test is meant to combat the debt and housing price issues in Canada. It would prevent borrowers from over-extending the amount of debt they can handle. Additionally, it would prevent lenders from issuing unnecessarily high-risk mortgages. Since its introduction, there has been a whirlwind of articles and commentary surrounding the test. No matter which side of the debate you fall on, the bottom line remains the same. Canadians looking to secure a mortgage will need to undergo the stress test for the foreseeable future.
What exactly is the stress test?
As of 2019, the stress test requires borrowers to qualify for a mortgage with an affordability buffer built in. This buffer ensures mortgage candidates will be able to continue their payments if interest rates increase. All buyers applying for a mortgage (both insured and uninsured) from federally regulated lenders must undergo the stress test. Before the government introduced the stress test, lenders determined maximum loan affordability during the qualifying process.
This is based on the size of the loan you had requested, your annual income, your debt obligations, your utility and living costs, your chosen amortization period, and the effective interest rate of your mortgage. After the implementation of the stress test, the majority of the criteria that lenders take into account has remained the same.
How do I qualify?
However, OSFI now requires that borrowers qualify for mortgages at their contracted interest rate (the effective rate on the loan) plus two per cent or at the Bank of Canada’s benchmark five-year rate – whichever is higher. For example, if the contracted rate is 3.56 per cent, borrowers will need to qualify for a mortgage at 5.56 per cent (as long as the benchmark rate is less than 5.56 per cent). A higher qualifying rate has the effect of increasing the mortgage payments lenders take into account when determining whether a borrower is able to afford loan payments.
While the qualifying rate is not the effective rate that is charged on a mortgage, using the +2 per cent buffered rate ensures payments can still be covered if economic circumstances change. By increasing the qualifying rate, OSFI has slashed the maximum loan amount that individuals will be able to qualify for, in some cases by as much as 20 per cent.
Preparing for the mortgage stress test
Unless you work for the Bank of Canada, there is not much you can do about the benchmark mortgage rate. What you can control is your financial position before applying for a mortgage. Lenders use a few critical calculations to assess your credit standing. This includes your ability to make loan payments. By understanding these metrics, you can make smart financial decisions before applying for a mortgage.
Gross Debt Service (GDS): The percentage of your pre-tax income that’s required to pay all housing costs. This includes your stress-tested mortgage payments, condo fees, utilities, and property taxes. All of these costs are calculated and then divided by your gross monthly income. Lenders like this ratio to be between 35 and 39 per cent.
Total Debt Service (TDS): This ratio factors in all your debt and represents how much of your monthly income you need to cover your debt. This calculation includes car payments, personal loans, student loans, credit cards, etc. Lenders would like this ratio to be no more than 44 per cent.
Is there any way you can avoid the stress test? You can apply for a mortgage loan with an institution that is not under OSFI’s jurisdiction. Opponents to the current B-20 guideline continue to argue that the changes are too strict. The government ideally wants to cool the housing market and reduce household debt. However, there is the risk of over-regulating, which can negatively affect the economy as a whole. It is important to take into account the perspective of those arguing against the stress test. Many of those who seek to gain from increased housing prices and risky loans will logically be opposed to the tighter regulations, even if the regulations are in the best interest of the economy.
If you have questions about the mortgage stress test, give me a call at (705) 333-4338 or get in touch with me here!