What is the Mortgage Stress Test?
If you live in Canada and you intend to apply for a mortgage loan in any of the major banks, you will be required to undergo a mortgage stress test. Since it is a legal requirement in the country, you should prepare for this if you are thinking about buying a home as it is a way to prepare against any mishaps in the future.
As important as this aspect of mortgage is, not many are aware of what it is or what the rules are, while others may have forgotten as the rules keep changing. Whichever category you belong to, this guide will help bring you up to speed so you can prepare for it if you plan to apply for a mortgage loan any time soon, whether you are a first-time buyer or you are refinancing your mortgage.
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What is the Mortgage Stress test?
We live in a world full of uncertainties, especially in finance. There may be changes in interest rates or the prices of homes. You may even lose your job in addition to other uncertainties. The Canadian government has therefore deemed it necessary to consider all these factors before giving you a mortgage loan. The process of using the factors to determine how much you qualify for is known as the mortgage stress test.
Basically, your lender models the worst case scenario to see if you can survive in it. If you lose your job and home prices go up in the future, will you be able to sustain your mortgage payments? You may pass or fail the test depending on the kind of home you wish to buy.
Why is the stress test important?
The stress test is performed for your own good and is necessary to protect you from losing your home when you fail to pay your mortgage if things don’t go well in the future. The test helps the lender to determine the most suitable loan for you, which you can service under the worst possible scenario and not lose your home.
How does the stress test work?
To stress test your mortgage, lenders use interest rates to determine if you will be able to pay by if the rate goes up. For example, assuming you wish to buy a house worth $500,000 and you make a 20% down payment of $100,000 and qualify for a 7-year fixed-rate mortgage of 2.46%, you may be able to pay.
However, will you be able to pay if the interest rate increases to 5.23%? The lender simulates this kind of change to see if you will still be able to pay the mortgage. If you can, then you have passed the test. If you are found to be unable, you have failed the test and may have to consider cheaper options.
Mortgage Stress Test Updates
Canada’s financial regulator, OSFI is responsible for reviewing the minimum qualifying rates for intending home buyers. The new mortgage stress test as of June 2021, increased the minimum qualifying rate from 4.79% to the current 5.25% for all uninsured mortgages (borrowers with a down payment of at least 20%) and insured mortgages (down payment of less than 20%). Subsequently, the rates will be reviewed annually.
Mortgage Stress Test Rules in Canada
The mortgage stress rules Canada has put in place state that as an intending home buyer, you have to pass a stress test. This means qualifying for your mortgage using the minimum qualifying rate.
For home buyers with less than 20% down payment, the lender will use either the insured minimum qualifying rate or the customer’s mortgage interest rate plus 2%. The higher rate is used for the test.
On the other hand, home buyers with a down payment of more than 20% will have to pass a test using either the OSFI minimum qualifying rate or the customer’s mortgage interest rate plus 2%, depending on which is higher.
How to Improve Mortgage Stress Test Results
While you cannot determine the rules for mortgage stress tests or control changes in interest rates, the following are few things you can do to improve the outcome of your mortgage stress test.
- Pay a larger down payment: making a larger payment deposit reduces how much you will have to pay monthly to offset your mortgage loan. This can quickly make your test outcome better.
- Clear off your debts: it can be overwhelming paying off debt and mortgage at the same time. It is advisable that you clear your debt first and you’ll have a lot more money left to pay your mortgage.
- Work to earn more: the more income your household has, the easier it will be to pay your mortgage. Waiting until your family is earning higher income is advisable rather than paying through your nose.
Frequently Asked Questions
A mortgage stress test is a test conducted by a lender to determine how suitable a borrower is for a particular mortgage amount. It is basically a simulation of the worst case scenario in the borrower’s income to determine if they can pay the mortgage under suich tough circumstances. All will-be home buyers are expected to pass this test in Canada, depending on whether they are insured or uninsured.
Stress tests are mandated for anyone looking to get a mortgage loan from a federally regulated lender such as the major banks in Canada. Therefore the only way to avoid a stress test is to borrow from a provincially regulated lender, such as a credit union. Your mortgage also needs to be uninsured for it to work. The downside is that you may end up paying a higher rate.
Of Course not all mortgage lenders use the stress test. The test is mainly for those seeking a mortgage with federally regulated lenders even though there are provincially regulated lenders that also use it. There are plenty of mortgage lenders at the provincial level who don’t use the stress test. They may just charge higher interest rates than the minimum the big banks charge.