Navigating the home-buying process in Canada can be challenging, particularly with the rigorous mortgage qualification requirements in place. One key aspect prospective homeowners need to be aware of is the mortgage stress test. This blog will delve into the origins of the stress test rules, how they are applied, the impact on the lending market, and offer tips for prospective borrowers.
The Origins of the Stress Test Rules
The mortgage stress test was introduced by the Office of the Superintendent of Financial Institutions (OSFI) in 2016. Initially, it was aimed at ensuring high-ratio mortgage borrowers (those with less than a 20% down payment) could afford their mortgages even if interest rates rose. By 2018, these rules were expanded to include all borrowers, regardless of their down payment size or whether they had insured or uninsured mortgages.
How the Rules Are Applied
The stress test requires that lenders assess a borrower's ability to make mortgage payments at a higher interest rate than the one they are being offered. Specifically, lenders use the higher of two rates: the Bank of Canada’s five-year benchmark rate or the mortgage interest rate offered by the lender plus 2%. This ensures that borrowers can handle potential rate increases over the term of their mortgage. As of July 2024, the Bank of Canada’s five-year benchmark rate is 5.25%. This means that if a borrower is offered a mortgage rate of 5%, they must qualify at 7% (the higher rate) to pass the stress test. This stringent qualification process helps safeguard both borrowers and the financial system against potential financial instability.
Where the Bank of Canada Benchmark Rate Comes From
The Bank of Canada benchmark rate is derived from the average five-year fixed mortgage rates posted by Canada’s major banks. The central bank reviews and adjusts this rate periodically to reflect changes in the lending market and overall economic conditions. This benchmark rate serves as a standard for lenders and helps ensure that the stress test remains effective in protecting both borrowers and the financial system.
Impact on the Lending Market
Since the inception of the stress test, the Canadian lending market has seen notable changes. Initially, the stress test led to a cooling of the housing market. Home prices in some overheated markets, like Toronto and Vancouver, stabilized or saw slower growth rates. The stress test has also reduced the risk of mortgage defaults by ensuring that borrowers are financially capable of managing their mortgage payments even in less favourable economic conditions. However, the stress test has also made it more challenging for some borrowers to qualify for a mortgage. This has particularly affected first-time homebuyers, who often have lower incomes and savings compared to repeat buyers. Some potential homeowners have had to either delay their purchase or seek homes in lower price ranges to meet the stress test requirements.
Tips for Prospective Borrowers
Assess Your Financial Health: Before applying for a mortgage, thoroughly evaluate your financial situation. Ensure you have a stable income, minimal debt, and a good credit score. These factors significantly impact your ability to pass the stress test.
Save for a Larger Down Payment: A larger down payment reduces the loan amount and increases your chances of qualifying for a mortgage. It also lowers your overall interest costs.
Improve Your Credit Score: A higher credit score can help you secure a better mortgage rate. Pay down existing debts, avoid taking on new debt, and ensure all payments are made on time.
Consider a Co-Signer: If you’re struggling to meet the stress test requirements, having a co-signer with a strong financial background can improve your chances of approval.
Shop Around: Different lenders may offer varying rates and terms. Don’t settle for the first offer; instead, compare multiple lenders to find the best deal that suits your financial situation.
