Buying a new home is already a stressful experience. With last year’s introduction of a mortgage stress test for all aspiring homeowners, that has only become more so. There are several requirements to meet before a successful application, and the aspiring homeowner must be sure they will be able to meet the monthly payments before applying.
What is it?
The mortgage stress test is designed to ascertain that the applicant is able to keep up with their payments even in the face of changing interest rates. So you will need to qualify at your contracted mortgage interest rate plus two per cent or the Bank of Canada’s five-year benchmark rate, whichever is greater. As of May of this year, the five-year conventional rate is 5.19 per cent, the first drop since May 2018 where it rose to 5.39 per cent.
In real terms, the stress test means that, for example, a borrower with 20 per cent down payment, no debts and an income of $100,000 a year could buy a house worth about $597,000.
“I think the policymakers will be pleased to (note) the slowing growth in home prices and the delinquency rates are quite low as well,” said James Laird, president of Toronto-based CanWise Financial. “At a high level, generally speaking it has achieved what it was designed to achieve.”
When was it created?
The test, created by the Office of the Superintendent of Financial Institutions in 2017, was meant to tackle the high household debt that Canadians have been facing. Originally, the test only applied to mortgages with less than a 20 per cent down payment and subject to default insurance premiums. As of October 2017, anyone applying for a mortgage must pass the test, including if they decide to switch to a different lender.
“The stress test was poorly designed,” said Rob McLister, founder of Toronto-based RateSpy.com. “It was based on a rate that six banks can manipulate and it traps an estimated 5-10 per cent of renewers with their existing lender.”
Rules around the stress test apply to the lenders, where they are required to further scrutinize the loan-to-value ratio of the mortgage to make sure the mortgages are not too large compared to the value of the home.
What’s the problem?
The test has proved controversial for some first-time homebuyers as it slashes their purchasing potential by as much as 20 per cent. It has also made it more difficult for current homeowners to refinance or renew their mortgages.
Many recent retirees have also faced difficulties with the stress test, since it looks at your current income as part of the requirements. For those looking to both retire and refinance their mortgage, it is best to plan a few years in advance to get the loan you need.
“Banks are motivated to keep 5-year posted rates high for their own economic self-interest, largely because it earns them more prepayment penalty revenue,” said McLister. “A fairer stress test would be the 5-year Canadian bond yield plus 300 to 350 basis points.”
Laird recommends the adoption of a 30-year amortization for first time homebuyers instead of 25.
“What that does is, increases affordability by about 10 per cent,” said Laird. “What I really like about that is on a month-to-month basis a household isn’t paying any more they’re just paying for a little longer period of time.”
That being said, the stress test can be avoided if you turn to lenders outside of federal regulations, like credit unions or some private lenders.
How can you prepare?
While you can’t do much to change the Bank of Canada’s five-year rate, there are some ways you can prepare for a mortgage stress test. Lenders use a few metrics when determining if you will be able to pay your mortgage on time. One is gross debt service ratio (GDS), which represents the percentage of one’s pre-tax income that’s required to pay all housing costs. This includes not just the monthly mortgage housing payment but all other monthly housing expenses like utilities and property taxes. Lenders typically want to see no more than 32 per cent GDS.
There is also the total debt service ratio (TDS), which includes all of one’s debts, like student loans, lines of credit and so forth. This should constitute no more than 42 per cent of your monthly pay in order to pass the mortgage stress test.
Getting a co-signer for your mortgage can also help you get a larger loan, and according to McLister there have been many more parental down payment “gifts” since the implementation of the stress test.
Special to the Financial Post
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