As of the 1st of January 2018, all Canadian buyers borrowing from a federally regulated lender will be subject to the OSFI Mortgage Stress Test, including insured borrowers (those with a down payments of 20% or more.)
Lenders will now have to qualify all conventional mortgages using the Bank of Canada’s 5-year benchmark rate, which is currently set at 4.99%, or at the current contracted rate + 2% if that rate exceeds the benchmark rate. So, if you are currently pre-approved at 3.5%, you will now have to qualify as if your interest rate were 5.5%, which could significantly reduce your buying power.
What is a mortgage stress test, and how is it calculated?
In finance,”stress tests” are ways of considering the worst-case scenario for any investment. When it comes to mortgages, stress tests determine the risks of each loan application. How much can the borrower afford given their current debt-to-income ratio, and would they still be able to make the monthly mortgage payments should the rates increase? How would their payments be affected in the case of a temporary job loss? These are all important factors in determining how likely a borrower is to default on their loan payments.
As of January 2018, home buyers will need to qualify not only for the rate negotiated as part of their mortgage contract, but also at their current rate + 2%, or the average bank 5 year posted rate of 4.89% (whichever is higher).
By “stressing” the mortgage this way, banks will ensure that the borrower would be able to service their loan under pressure, should the interest rates climb higher than the current average.
Additionally, borrowers should not exceed a 44% Total Debt Ratio (TDS), and will be required to spend less than 32% of their income on housing costs such as utilities, mortgage payments, and real estate taxes.
The Mortgage Stress Test (MST) were typically applied to insured mortgages, in which the borrower had put down less than 20% towards their downpayment. However, as of January 2018, all borrowers will be subjected to the new stress test.
How will the mortgage stress test affect your buying power?
The new stress test will automatically reduce your borrowing capacity by a minimum of 18.5%. The larger the gap between your pre-approved interested rate and the stressed rate will further impact/reduce your borrowing capacity.
For example, if you were pre-approved at 2.49% , your mortgage would now be subjected to a stress-test against a rate of either 4.49% (current rate +2%), or against the posted rate of 4.89%. Since the posted rate is higher, this is the rate that will be used in the stress test. Your borrowing capacity would decrease by ~22.50%.
If you have already been pre-approved, you can use the quick formula to determine an approximate reduced borrowing power capacity under the new stress test regulations.
Reduction in buying power = (Current pre-approval * minimum reduction 0f 18.5%)
Assuming you have been pre-approved for a $300,000 mortgage.
Reduction = (Current pre-approval * minimum reduction)
Reduction = ($300,000 * 0.185)
Reduction = $55,500
New loan capacity = $244,500
Assuming your family earns an annual gross income of $100,000, and you plan to buy a home 20% down. You have been pre-approved for a loan of $726,939 at a 5 year fixed mortgage rate of 2.83%.
Under the new mortgage stress rules, you will need to qualify at the benchmark rate of 4.89%. Now, your family can only afford a home worth $570,970— a budget cut of $155,969.
Who is most at risk of being affected by a stress test?
Buyers who are shopping at the upper end of their budgets, and who spend a high proportion of their gross income on housing expenses, will be at the highest risk.
The effect is lessened for those buyers who are shopping well below their pre-approved budgets, and who expect to spend less than 32% of their income on housing and mortgage costs.
How can you increase your borrowing capacity?
Borrowing capacity is based on your ability to service the loan provided by your chosen financial institution and is very much geared towards your GDS (Gross Debt service) and TDS (Total Debt Service) ratios. Any increase in these ratios will in-turn decrease your borrowing capacity.
Factors which will reduce your GDS/TDS ratio, and increase your borrowing capacity:
- TDS/GDS – Putting down a higher down-payment, thus decreasing your mortgage debt and your monthly mortgage costs.
- TDS/GDS – Having an increase in your (gross) household income.
- TDS Only – Reducing your current debt obligations (car payments, credit card interest, etc)
Prospective home buyers who have been impacted by the new legislation may be required to shop for more affordable homes, such as BMV properties and hot market deals.
All in all, we recommend protecting yourself against the new stress test regulations, by purchasing or refinancing your home before January 2018.