In this post I will write about the stress test and what it meant for Canada. If you have bought a property since the introduction of the stress test in Canada, then you may remember that the Office of the Superintendent of Financial Institutions (OSFI) first mandated a stress test on all insured mortgages in October 2016. It was intended to help cool off the market. They formalized the stress test for all uninsured mortgages by January 2018.
The stress test, a crucial requirement for all potential homebuyers, mandates borrowers to qualify at either the Bank of Canada’s minimum qualifying rate (currently 5.25%) or their contracted mortgage rate plus two percentage points, whichever is higher. This ensures borrowers can withstand potential interest rate hikes during their mortgage term. Before we delve into the reasons behind its introduction, let’s first understand who is obligated to undergo this test.
The stress test is a prerequisite if you are obtaining a newly insured or uninsured mortgage, which means a mortgage with less than 20% down or more than 20% down. But that’s not all – It’s also mandatory for anyone refinancing their mortgage with a federally regulated lender, applying for a home equity line of credit (HELOC) or second mortgage with a federally regulated lender, or switching to a new federally regulated lender when renewing their mortgage. However, from January 1, 2024, borrowers will be exempt from the stress test when renewing with a new lender, as long as their mortgage amount and amortization period remain unchanged.
I could have said it applies to everyone, but I wanted to highlight the specifics to underline the scale of this change’s impact.
The stress test was introduced to ensure buyers can withstand potential interest rate increases during their mortgage term. It confirmed whether they could still afford their mortgage payments should the interest rates rise.
While the Total Debt Service (TDS) ratio already existed to prevent over-borrowing, the stress test was introduced to add another layer of safeguard, to see if the TDS became beyond permissible if the interest rates changed. In effect, the stress test reduced the total debt service ratio. By stress testing at a higher qualifying rate, the mortgage stress test takes a preemptive approach to evaluate a borrower’s ability to absorb higher costs before they occur, providing a preventive safeguard against interest rate risk for borrowers and lenders—a lesson learned from the 2008 global financial crisis.
The stress test takes a longer-term view by considering potential payment increases rather than just looking at affordability at the current low rates. This helps ensure the home remains affordable for the buyer over the entire amortization period.
The stress test not only protects lenders but also safeguards the broader economy from future defaults and foreclosures. By qualifying at a higher rate, the stress test builds a buffer into mortgage approvals, making homebuyers more resilient to interest rate hikes during their mortgage term. This significantly reduces the risk of being forced to sell or face foreclosure due to unaffordable payments, thereby ensuring a stable housing market.
Having said that, it also forces buyers to reduce their purchasing power virtually. The limited purchasing power can price out some buyers from the neighbourhoods they desire.
To match the monthly outflow in a desired home, some buyers may have to delay their home purchase plans until they can save a larger down payment to qualify for the mortgage amount needed under the stress test rules.
Reduced buying power during low interest rates helped the overall market by restricting investors’ speculative buying. I can’t imagine what would have happened if the stress test had not been in place during the lowest-ever interest rates during COVID-19.
From a buyer’s perspective, I have heard several criticisms of stress tests that do not account for future income growth. I still believe it only helped by not allowing overextension on their budgets.
Widespread defaults due to overextended borrowers could destabilize the housing market. The stress test aims to mitigate this systemic risk by ensuring borrowers can keep making payments.
In closing, the mortgage stress test benefits homebuyers by promoting responsible borrowing within their means, safeguarding their long-term financial well-being, and contributing to a more stable housing market overall.
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