For many aspiring homeowners, the process of applying for a mortgage can be stressful, especially in a high interest rate environment. The Canadian housing market has been subject to extreme fluctuations in recent years, making it harder than ever to afford your first home. Introduced in recent years, the mortgage stress test serves as a safeguard against financial instability, ensuring Canadians can withstand potential interest rate hikes and remain financially secure over the long term.
Below, we’ll uncover everything that you need to know about the mortgage stress test, including how it works and the implications for prospective homebuyers.
What Is The Mortgage Stress Test?
A mortgage stress test is a financial assessment used by lenders to determine whether a borrower can afford mortgage payments under certain conditions, such as higher interest rates or changes in income. It’s designed to ensure that borrowers can still meet their mortgage obligations even if they face financial challenges in the future.
Why Is The Mortgage Stress Test Required?
The mortgage rate stress test was introduced in Canada in 2018 by the Office of the Superintendent of Financial Institutions (OSFI) as part of the B-20 guidelines. Its implementation aimed to enhance the resilience of the Canadian financial system by ensuring that borrowers could withstand potential interest rate increases.
While the stress test may make it more challenging for some borrowers to qualify for mortgages, it is intended to promote responsible lending practices and protect borrowers from financial hardship in the event of rising interest rates.
How Does The Mortgage Stress Test Work?
In Canada, a mortgage rate stress test is a financial assessment imposed by regulatory authorities on borrowers applying for certain types of mortgages, especially those with down payments of less than 20% (known as high-ratio mortgages).
Here’s how a mortgage stress test typically works:
Qualifying Rate
Borrowers are required to demonstrate that they can afford mortgage payments at a higher interest rate than the one they will be paying. This higher rate, known as the qualifying rate, is typically set by regulatory authorities and is based on the Bank of Canada’s five-year benchmark rate or the contract rate plus 2%, whichever is higher.
Payment Calculation
Using the qualifying rate, lenders calculate the mortgage payments for the requested mortgage amount, amortization period, and payment frequency (e.g., monthly, bi-weekly).
Affordability Assessment
The lender evaluates whether the borrower can afford the mortgage payments at the qualifying rate. This assessment considers the borrower’s income, existing debts, and other financial obligations.
Debt Service Ratio
Lenders use the debt service ratio (DSR) to assess affordability. The DSR compares the borrower’s total debt payments (including the mortgage) to their gross income. A lower DSR indicates better affordability.
Approval or Adjustment
If the borrower passes the stress test and meets the lender’s affordability criteria, they may be approved for the mortgage. If not, they may need to adjust their mortgage amount or consider other options to improve their financial situation.
