The Mortgage “Stress Test”
What is the “Stress Test,” how is it determined, is it a good thing, and how does it affect you? Inescapably, it will affect the applicant when applying for their next mortgage, so it is essential to know about it. This article will explore the stress test, help prepare for it and factor it into a mortgage plan.
What is the Stress Test? The stress test is not really a test. It is a set of mortgage rules and a mortgage qualification interest rate implemented and determined by the federal government to protect Canadians and the housing market. All federally regulated financial institutions are obligated to use the stress test interest rate for mortgage qualification purposes. The stress test rate determines the maximum eligible mortgage value and not the actual mortgage payment. Only once an applicant qualifies for their mortgage at their stress test interest rate are they eligible for their lender’s lower, contract [actual] interest rate.
Prior to introducing the stress test, the mortgage lender’s contract interest rate was the same as the mortgage qualification interest rate.
Because the qualification interest rate was the same as the contractual interest rate, borrowers qualified for a lot higher mortgage and house prices than they would today. Historic low-interest rates and rapidly increasing property prices caused concerns that applicants may not be eligible for their mortgages if the interest rates increased in the future and that rising house prices would outpace affordability and make homeownership unattainable for many Canadians.
In response to these conditions, the federal government implemented the stress test in October 2016 for insured mortgages and in 2018 for conventional mortgages.
The stress test rules have two primary objectives:
- Slow down the housing market growth: The substantially higher mortgage qualification interest rate would make it harder for applicants to qualify for mortgages. The government anticipated that this would, in turn, cause fewer applicants to be eligible for mortgages, reduce the mortgage demand and slow down the property growth rates.
- Improve Future Mortgage Qualification Risks: Because the stress test interest rate qualifies higher than the contract rate, it allows for a better chance to be eligible for a mortgage if the mortgage rates increase in the future.
Mortgage applicants may not like the stress test, whether as a first-time homebuyer, new immigrant or when living in an area where the housing market is not growing aggressively as the stress test rules can prohibit qualifying for a mortgage, but as we shall see from examples, the stress test rules play a part in protecting Canadians and the housing market.
The federal government has set the stress test interest rate at the higher of the Bank of Canada’s [BOC] 5-year benchmark rate or the financial institution offering the mortgage loan’s contract interest rate plus 2%. This is a lot to process, but once we have defined each term and used an example, it should be easier to understand:
- BOC 5-year Benchmark Rate: This rate is the mode average 5-year posted rate of Canada’s six largest banks. The BOC publishes this rate on its website. Search for the “Conventional Mortgage,” 5-year rate under CANSIM code V80691335. As of this writing, the BOC 5-year benchmark rate is 4.79%.
- Financial Institution’s Contract Rate + 2%: The lender’s contract interest rate determines the actual mortgage payment once the applicant has qualified for the mortgage at the stress test interest rate. The contract interest rate should be lower than the stress test interest rate. Still, each mortgage lender can determine the contract interest rate; hence, the stress test rules require a test to be conducted to ensure the BOC 5-year benchmark rate is at least 2% higher than the lender’s contract interest rate + 2%. This test is not always straightforward, especially for home loans with more than a single loan component, as each loan component has its own interest rate. Here is how it works:
- Home Loan with a Single Loan Component: This is straightforward; take the contract rate + 2%. E.g. If the loan’s contract rate is 2.5%, then calculate 2.5% + 2% = 4.5% and compare that to the BOC 5-year benchmark rate.
- Home Loan with More than One Loan Component: Where a loan has more than one component, the stress test rules determine we must use the highest interest rate of all of the loan components for our test, irrespective of the rate type or size of the loan component, etc. E.g. Let us say we have a home loan with two components; a mortgage plus a Home Equity Line of Credit [HELOC]. Assume the mortgage contract rate is fixed at 2.34% and the HELOC’s rate is variable at Prime [P] + 0.6% [2.45% + 0.6% = 3.05%]. [As of this writing, most financial institutions’ prime lending rate is 2.45%]. There are two different interest rates in this example, so which one should we use for our test? The HELOC has the higher interest rate of the two loan components. Thus the HELOC interest rate will be used for the entire loan to check whether the contract rate + 2% is lower or higher than the BOC 5-Year benchmark rate. A quick calculation shows that the contract rate plus 2% equals 5.05%. [3.05% + 2%= 5.05%]
Before calculating the stress test interest rates for our examples above, let us reiterate that the mortgage stress test interest rate is determined by the higher of the BOC 5-year benchmark rate or the financial institution’s mortgage loan contract interest rate plus 2%.
Assuming a BOC 5-year benchmark rate of 4.79%, the mortgage stress test interest rate for each of the above examples are:
- Home Loan with a Single Loan Component: The contract rate + 2% [2.5% + 2% = 4.5%] is less than the BOC 5-year benchmark rate [4.79%]; thus, the stress test rate for this loan will be the higher 4.79% BOC 5-year benchmark rate.
- Home Loan with More than One Loan Component: The contract rate + 2% [3.05% + 2%= 5.05%] is higher than the BOC 5-year benchmark rate [4.79%]; thus, the stress test rate for the entire loan will be the higher 5.05%, contract rate +2%.
Here are a few important notes and things that need to be known that may seriously affect the applicant about the stress test:
- The stress test interest rate is not fixed in time: Since the BOC 5-year, benchmark interest rate and the lender’s contract interest rates can change at any time, the stress test interest rate can change without prior warning or notice.
- The higher the stress test rate, the lesser the mortgage eligibility: This may seem obvious, but it can be disastrous if the plan is to purchase a property to the maximum value of the mortgage qualification ability, as it may no longer qualify the applicant for the mortgage they need if the stress test rate increases. The applicant must confirm what stress test rate was used to qualify for the mortgage. The applicant should follow up with the mortgage broker to ensure that the mortgage’s stress test interest rate has not increased.
- Pre-approvals do not lock the stress test interest rate: The pre-approval or pre-qualification does not lock the stress test interest rate.
Thus, the pre-approved mortgage amount will reduce if the stress test rate increases regardless of pre-approval.
- The stress test is not a universal interest rate: As we have shown above, the stress test rate is determined by multiple factors such as the mortgage product chosen, the BOC 5-year benchmark rate, etc.; thus, the stress test interest rate must be determined for each applicant’s unique situation, and it cannot be quoted as a single interest rate that fits all situations.
This also means that the stress test interest rate for a particular product or circumstance may limit eligibility for a mortgage or mortgage product the applicant requires.
- Contract rates do not determine the mortgage eligibility: It is logical to assume that when interest rates are low, the applicant will be eligible for a higher mortgage amount, but as we determined, but this is not true because the stress test interest rate determines the applicant’s mortgage eligibility and not the contract interest rate. The contract interest rate does, however, affect the budget because it determines the actual mortgage payment.
- Unintended consequences of the stress test: If the applicant obtains a mortgage from a financial institution when the stress test rate is lower, they may not be eligible for the same mortgage later if the stress test rate increases. This means that they would not be able to change their mortgage and/or move the mortgage to a different lender later if they wish to, and they could be “trapped” with that lender for a while, so make sure the lender’s terms & conditions are understood and they are best suited to the applicant’s needs and circumstances.
- The applicant will qualify for less mortgage than before: The stress test interest rate will cause the applicant to be eligible for a lesser mortgage than prior to the stress test rules implementation, using the same income. Be well prepared before applying for a mortgage.
- Does the stress test affect the applicant?: The mortgage stress test applies to all federally regulated financial institutions, so anyone applying for a mortgage from such financial institutions is subject to the federal stress test rules, irrespective of down payment, credit, house price, property occupation, etc.
To understand the stress test rules and protect against disappointment or even financial loss, we highly recommend setting a meeting with us to discuss and determine various eligible mortgage options for your needs and circumstances.
- For information purposes only and the information is incomplete, not conclusive and cannot be acted upon.
- Based on estimates
- Subject to terms & conditions
- Based on approved credit
- Subject to change without prior warning or notification.
- Guidelines may vary significantly between lenders, mortgage loans, property types, credit, etc.