Canadians Short Of Breath With New Mortgage Stress Test

Beginning in January 2018, the Office of the Superintendent of Financial Institutions (OSFI) has prescribed new mortgage rules for Canadian homebuyers. Emphasizing a 'stress test' for affordability, the changes are intended to reduce and eventually eliminate situations where people are borrowing beyond their means – especially in an environment of increasing interest rates.

Due to the stringent new requirements, the move promises noticeable changes to the national housing market and may delay or even reverse homeownership for tens of thousands across the country.

Introducing the 'stress test'

Among the most noteworthy new guidelines coming into effect is the aforementioned stress test for new borrowers, refinancing and switching to a new lender. From 2018 onward, all federally licensed lenders will be required to run a simulation to determine how effectively a borrower could weather a significant increase to their interest rate without defaulting on their mortgage.

Although similar guidelines are already in place for borrowers with less than a 20 percent down payment on their home, the new regulations will apply to all individuals regardless of their down payment, with the only exception being renewing their mortgage with an existing lender.

How does the stress test work?

According to the previous regulations, borrowers with a 20 percent or greater down payment would automatically qualify for the maximum available mortgage value given their income and proposed interest rate offered by a financial institution. For example, if a couple approached a bank for a pre-approval and were offered $500,000 with a 3.2 percent five-year fixed interest rate, they could purchase any home up to and including that value.

With the new regulations, however, borrowers must now qualify on the assumption the rate might increase significantly over the lifetime of their mortgage. Lenders will be required to model their ability to afford a mortgage either two percent higher than the proposed rate or at the five-year average mortgage rate posted by the Bank of Canada (4.99 percent at the time of writing), whichever is higher.

So, continuing with the above example, if the same couple wanted to purchase a $500,000 home – even though their bank is offering a 3.5 percent interest rate, they must demonstrate they can afford the home at 5.5 percent, since that is two percent higher than their pre-approval and higher still than the Bank of Canada rate.

Should the couple fail the stress test, they would be forced to settle for a mortgage amount lower than their original pre-approval which they would be able to afford given that 5.5 percent five-year fixed interest rate. In some cities that may mean the difference between a house and a condo. In others, it may mean the difference between buying a home or not at all.

When is the stress test applied?

There are three situations when the stress test is applied:

• When a borrower is looking to obtain a mortgage for the first time, regardless of their down payment.
• When a borrower is seeking to refinance their existing mortgage
• When a borrower is looking to switch lenders at the time of renewal.

Currently there is no requirement for the stress test to be applied if a borrower is renewing their mortgage with their existing lender – even if their rate goes up significantly.

Beware of variable rate mortgages

Borrowers will typically strive to qualify for the highest mortgage amount possible at the lowest possible interest rate. Unfortunately, this often means succumbing to the temptation of a variable rate mortgage – which fluctuates based on current market conditions and is almost always lower than current fixed-rate offerings.

When interest rates are extremely low – as they have been for several years – this can translate into what seems like significant savings. However, it can also translate into large, unexpected hits to the bottom line, as recent events have shown. Sudden changes to the Bank of Canada's overnight interest rate can result in sudden measurable increases in monthly expenses which borrowers are usually not prepared for. This makes it difficult to make ends meet, can cause debt to accumulate in other areas and ultimately challenge their ability to keep up with payments.

For those in a tight financial position, it is almost always best to have a fixed rate mortgage. While interest rates will typically be higher, it is easier to budget knowing what the monthly payment will be and having the assurance it won't dramatically increase every time the Bank of Canada announces a rate hike.

Increasing the amortization term

Another way borrowers will try to get ahead is by increasing their amortization period to lower their monthly payments. Traditionally, most mortgages will be amortized over 25 years for a first-time home purchase. If, during their first five-year term, a mortgagor takes on more debt than they can manage, they may find it progressively difficult to keep up with their mortgage payments. When it comes time to renew, they may realize the only way they can afford their housing costs is to reset their amortization at 25 years or increase the mortgage term to 30 years to lower the payment even further.

This is a red flag. For one, it dramatically increases the amount of interest that will be paid over the lifetime of the mortgage. It also puts a bigger gap between the borrower and their eventual goal of having a debt-free home.

Safe to renew the existing mortgage? Maybe.

For some Canadians, the thought of enduring this stress test is just as stressful. Rather than risking failing with another lender, they may think their best option is to stay put with their current lender and do nothing. The question is, are they safe to do that? Maybe and maybe not.

Given there have not been problems with the borrower's payment history, most lenders will likely be happy to renew the mortgage. The interest rate will almost certainly be higher, and the borrower won't benefit from the advantage of a competitive rate from another lender – so the bank has all the leverage.

However, there is nothing stopping them from performing a credit check, re-evaluating the borrower's income and their ability to support the existing mortgage which could impact the renewal. As interest rates continue to increase, it is a risk this will become common practice among most lenders.  

Recommendations:

Amidst so much uncertainty, it may feel as if the cards are stacked against the borrower. However, there are still some steps that can be taken to maximize the chances of securing a mortgage or keeping the existing mortgage once it comes time to renew.

• Avoid the temptation to borrow up to the maximum amount approved. This will usually be far higher than a person's comfort level. Determine what can be reasonably afforded to pay each month and stick with it.
• Consider talking to a mortgage broker. These professionals search for competitive rates and will find the best possible deal for the borrower's situation. If they've been through a consumer proposal or bankruptcy, the broker can look for lenders who understand the situation. A broker will usually charge a fee – one should ask how these are charged to avoid any surprises down the line.
• Consumers should review their credit report annually to be familiar with their credit history, ensure everything is accurate and understand how the credit rating and credit score will affect the amount and terms of mortgage for which they will qualify.
• If someone is worried they can no longer manage their non-mortgage debts, speak with a Licensed Insolvency Trustee.  A consumer proposal can assist by re-structuring the non-mortgage debt (e.g. credit cards, lines of credit, loans, etc.) to make it more affordable and prevent defaulting on the mortgage.