What is the Mortgage Stress Test?

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Are you looking to buy a home in Canada but have no idea what is the mortgage stress test? Even though the Canadian government announced the mortgage stress test back in 2017, it still causes a lot of confusion among potential buyers. It doesn’t help that the rules have changed a few times, so knowing how it works is essential if you buy a home. 

It doesn’t matter if you’re applying for a new mortgage or renewing with a new lender, the mortgage stress. Some people find this test annoying as it limits how much home they can afford. While that’s undoubtedly true, you could argue that the stress test is a good thing since it’ll ensure you’re prepared when mortgage rates increase. More importantly, this stress likely isn’t going anywhere, so you might as well get used to it. Here’s how the Canadian mortgage stress test works.

What is the mortgage stress test?

Even though mortgage lenders use their own criteria to determine how much they’re willing to lend you, you still need to pass the mortgage stress test to qualify. This is what annoys many people as the mortgage stress test effectively lowers the amount you can borrow. Considering real estate prices in Canada have increased so quickly over the years, every dollar counts.

While having access to more funds could help you with your house hunting, the mortgage stress test was introduced to ensure you don’t overspend. Instead, it’s in place to protect you when mortgage rates eventually go back up. To pass the stress test, you need to prove that you have the income to meet the higher of the following scenarios:

  • The rate your lender has offered you plus 2%
  • 5.25%

How this applies to you depends on what mortgage rate you’re getting and how much you’re borrowing. Let’s say your lender will provide you with a mortgage of $500,000, amortized over 25 years, at a rate of 2%. That means your monthly payment would be $2,117.26. However, you need to qualify at 5.25% due to the mortgage stress test, which would put your monthly payments at $2,979.59. That’s an $862.33 difference, which is a fair amount. 

For reference, before June 1, 2021, the mortgage stress test was just 4.79%, so it’s harder to pass the stress test. Note that even though it’s called a test, you can’t fail. You’d just not be able to borrow as much money.

How much mortgage can I afford?

In most cases, lenders use two ratios to figure out how much you can afford: the gross debt service (GDS) and the total debt service (TDS). With the GDS, lenders don’t want your housing costs to exceed 32% of your pre-tax income. Housing costs would include your mortgage payments, maintenance fees, utilities, and taxes. Under the TDS, lenders add any outstanding debt such as student loans, credit card balances, and auto financing to your GDS. That number can’t exceed 40% of your total income.

Using the scenario above, let’s say that maintenance fees, hydro, and property taxes are going to add another $800 a month to your housing payments. Your total monthly housing payments would be $2,917.26. As long as that amount is less than 32% of your pre-tax income, then you would pass the stress test. Of course, you still need to pass the mortgage stress test. The government of Canada has an outstanding mortgage qualifier tool, so you can figure out exactly how much you can afford.

It’s worth noting that if you require Canada Mortgage and Housing Corporation insurance, they have their own rules, which may affect your affordability. Your GDS can’t exceed 35%, and your TDS can’t be higher than 42%. 

How to avoid the mortgage stress test

Here’s the thing about the mortgage stress test, it only applies to federally regulated lenders. That would include all the major players such as RBC, BMO, Scotiabank, TD, and CIBC. However, the stress test only applies to federally regulated financial institutions. Credit unions are regulated provincially, so the stress test doesn’t apply to them. That doesn’t mean a credit union is less reliable or regulated. In fact, more than 10 million Canadians have an account with a provincially regulated credit union. They just use their own criteria to protect their members. There are also monoline lenders (private lenders) that don’t apply the mortgage stress test when extending you a mortgage.

Another trick to skip the mortgage stress test is to renew with your current lender. The terms may not be as favourable as some of the other lenders at the time of your renewal, but you won’t have to deal with the test. Of course, you could also just save more or borrow less, so the stress test won’t matter much to you. 

While looking for ways to avoid the mortgage stress test is understandable, you need to keep in mind that the rules are in place to protect you. Mortgage rates have been incredibly low for the last ten years, and there hasn’t been much of an increase. That said, rates can’t stay low forever, so you need to be prepared for when the cost of your mortgage eventually rises. Always have a buffer in your budget for unexpected expenses.

How does the stress test affect me?

It really comes down to affordability. Using the same example from above again, we’ve already established a monthly difference of $862.33 for mortgages of $500,000 that have an interest rate of 2%. Even though the stress test is theoretical, the government wants to ensure that you can afford the higher payments.

Since you’re always forced to factor in the higher rates, financial institutions can’t lend you as much money as they could have in the past. Again, most people are annoyed by this, but Canada has some record-high debt levels, and the government has implemented the mortgage stress test as one tool to help you manage your budget.

How to get the best mortgage rates

Even with the stress test in place, you should still strive to get the lowest mortgage rates possible. In most cases, using a mortgage broker can be beneficial to you. When you go to individual banks, they can only offer you the rates that they have available. However, mortgage brokers work with many lenders (sometimes 30+), so working with them is often better. 

Best of all, with mortgage brokers, you don’t need to do much work. Once you share some general information with them, they’ll shop for the best mortgage on your behalf. In just about every scenario, you’ll be offered better rates than what’s posted on the bank’s website. More importantly, mortgage brokers will be able to answer any questions you have about the mortgage process, including how the mortgage stress test will affect you.

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Home buyer incentives and perks

While the Canadian mortgage stress test will lower the amount you can borrow, there are also a few programs available that can help you increase your purchase price or lower your down payment. 

First-Time Home Buyer Incentive

The First-Time Home Buyer Incentive (FTHBI) is a relatively new program available to Canadians. Under the FTHBI, the government will provide you with 5% or 10% of the purchase price of a home. While this can be handy, you give up an equal amount in equity. For example, if you took 10% from the government, they would get 10% of the fair market when you sell or after 25 years.

Admittedly, this sounds like a good deal, but that equity you’re giving up is a fair amount. You also still need to come up with the minimum 5% down payment. The extra 5% or 10% that the government provides you with is meant to help you lower your monthly payments. To further complicate things, there are strict conditions for the FTHBI, so not everyone qualifies for it.

Home Buyers’ Plan

A more practical incentive is the Home Buyers’ Plan (HBP). If you’re a first-time home buyer, you’re allowed to withdraw up to $35,000 from your Registered Retirement Savings Plan (RRSP) tax free if you’re using the money as part of your down payment. This perk is available to both partners, so a couple could withdraw up to $70,000 from their RRSPs.

The HBP is clearly beneficial, but you’re essentially borrowing from yourself. You need to pay back 1/15 of what you borrowed every year, for 15 years, starting from the second year in which you withdraw the funds. If you miss a payment, it’s considered taxable income, and you permanently lose that contribution space. Overall, using the HBP to increase your down payment is a helpful strategy as it would help you pass the Canadian mortgage stress test.

Final thoughts

The mortgage stress test was a reasonable thing for the Canadian government to introduce, but it’s effortless to avoid. That said, you really shouldn’t be trying to get around it since you could be taking on too much debt. A sudden rise in interest rates could bust your budget, but the mortgage stress test is meant to soften the blow.

About Barry Choi

Barry Choi is a Toronto-based personal finance and travel expert who frequently makes media appearances. His blog Money We Have is one of Canada’s most trusted sources when it comes to money and travel. You can find him on Twitter:@barrychoi

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