No one likes to have their stress levels tested…
Unfortunately, in the world of Canadian mortgages, the mortgage stress test can make the application process a bit more complicated and, well, a bit more stressful… So let’s remove some of this stress by taking a look at:
- What the stress test mortgage is.
- Updates to the rules in 2020.
- How to avoid the stress test.
What is the Mortgage Stress Test?
The mortgage stress test was implemented in 2017 in order to reduce the amount of mortgage that Canadians can qualify for. There are two main reasons for reducing mortgage qualification:
- In the event that mortgage rates increase in the future, like at renewal, then the borrower would have already proven their affordability at the higher stress test rate. So it is like a safety mechanism for the homeowner.
- It reduces the purchase price of the home that a borrower can afford. Because the stress test lowers the mortgage approval amount, it also lowers the maximum purchase price of the home the borrower will be able to buy. The idea here is that this stabilizes the housing market and reduces chances of a housing bubble.
So in summary, the stress test is meant to add stability to the homeowner’s long term affordability of the home, and also stability to the housing market.
How does the Stress Test Work?
The stress test is essentially a high interest rate that is used on a mortgage application, that a mortgage broker or bank will use to qualify you.
The stress test rate is not a real interest rate that you see on a mortgage approval document, or that your payments would be based on. Instead, it is a high rate that is literally made up to lower the amount of mortgage you qualify for.
Specifically, the stress test rate lowers mortgage approvals by about 20%.
So for example, let’s say you were to qualify for $500,000 of mortgage using an interest rate of 2.49% for 5 years fixed.
Using the stress test rate of 4.95% (a 2.5% higher rate than the actual mortgage rate your payments are based on), your maximum mortgage qualification would be lowered to $400,000. In other words, by qualifying you at 4.95% instead of the contract rate of 2.49%, this reduces your mortgage approval by about $100,000.
Clearly, this impacts how much home you would be qualified to buy.
Stress test 2020 Rules Update
When the stress test was first implemented in 2017, the rate itself was literally just arbitrarily set by the Federal Government.
Now in 2020, the rules have changed so that the stress test rate more closely reflects the actual interest rates in the Canadian mortgage market. In other words, the rate is no longer arbitrarily set, but it it will now float based on actual market interest rates.
So while the effects of the stress test are mostly the same, the idea that the stress test can now move down as market rates move down is a more fair and accurate idea of what a stress test should be.
This does help the homeowner afford more home, although so far since the rules have changed – not by too much. The average mortgage applicant may not get an extra $10,000 – $25,000 in a mortgage approval, depending of course on the mortgage size.
Avoiding the Mortgage Stress Test
The stress test mortgage is regulated by the Federal Government of Canada, which means that any banks and lenders also regulated by the Federal Government are subject to the stress test. However, credit unions are regulated by Provincial governments and Provincial governments do not apply the stress test to mortgages.
So there is a limited number of credit unions that will allow applicants to borrow on the actual contract rate. Unfortunately, in most cases, this contract rate is quite a bit higher than the usual discounted rates offered by Banks and other mortgage lenders. So there is a downside here to using a ‘non stress test’ credit union mortgage because this type of mortgage literally will cost thousands more due to the higher rate. The rate may be up to 1% higher than what the bank or mortgage broker is offering.
One way to keep a low rate and to avoid the full impact of the stress test is to use a 30-year amortization instead of a 25 year amortization. While a 30-year amortization may cost about 0.20% or so more than a 25-year amortization, it can help to lessen the impact of the stress test. The one catch with the 30-year amortization is that the borrower needs a minimum 20% down payment on a purchase.
For more clarification on the stress test mortgage in Canada, more strategies to qualify for more, and lower your cost of borrowing, connect with us at Altrua and we will be happy to discuss.