P.T. Barnum once said, "There is scarcely anything that drags a person down like debt," and while this can serve as a warning to debt-laden Canadians, it also speaks to the country as a whole.
The debt level in Canada is growing. In fact, recent studies revealed that the average level of household debt in the country has increased significantly over the last few years.
In an effort to mitigate this, the government, through the Office of the Superintendent of Financial Institutions Canada (OSFI), proposed some changes to Canadian mortgage and housing rules. These include the introduction of a new mandatory “stress test," which was implemented early this year.
Under the ruling, Canadian buyers, including insured borrowers (those with a down payment of 20% and up) who borrow from a federally regulated lender will now be required to take the Mortgage Stress Test.
Lenders will have to assess all conventional mortgages using either the Bank of Canada’s benchmark rate, which is presently at 4.99%, or at the current contracted rate + 2% if that rate goes beyond the benchmark rate.
To further guide you on this topic, below are five points you need to keep in mind.
1. The Mortgage stress test is a TEST you need to pass.
Just like a school exam, the mortgage stress test is something you need to pass, and hopefully ace. The goal of the test? To measure risks of your application and determine how you will take charge of your loan payments.
The test will assess how much you, as a borrower, can afford given your debt-to-income ratio. Further, it also aims to ascertain if you will still be able to pay your monthly mortgage payments when rates increase. It will also evaluate some worst case scenarios and find out how you'll manage your payments despite challenges.
By “stressing” or examining mortgages under pressure, banks will be able to see if you would be able to vouch for your loans should rates become even higher.
Also, it is important to note that, as a borrower, you are required to not exceed a 44% Total Debt Ratio (TDS), and spend less than 32% of your income on housing expenses such as utilities, mortgage payments, and real estate taxes.
2. It reduces your borrowing capacity.
So, you need to qualify for a certain amount for your mortgage application to be improved, what does that mean now?
The stress test will reduce your borrowing capacity, full stop. If you are looking for a home, you may need to look for a less expensive property. Mortgage-holders looking to refinance are more likely to stay with their lenders to avoid the stress test, but this is also saying that their limiting their options.
When numbers are calculated, you will see that the new stress test will automatically reduce your borrowing capacity by a minimum of 18.5% -- the more significant the gap is between your pre-approved interested rate and the stressed rate, the more your borrowing capacity will be impacted.
Real estate agency Shupilov gave an example: "If you were pre-approved at 2.49%, your mortgage would now be subjected to a stress-test against a rate of either 4.49% (current rate +2%), or against the posted rate of 4.89%. Since the posted rate is higher, this is the rate that will be used in the stress test." Once you cruch the numbers, your borrowing capacity will decrease by about 22.50%.
3. Be aware of your Gross Debt Service (GDS) and Total Debt Service (TDS) ratio.
If you are looking to increase your borrowing capacity, then you should start watching your Gross Debt Service and Total Debt Service ratio. Why? Increases in either will reduce your borrowing capacity.
These two terms have been mentioned before in this article, but you might not be aware of the part they play in the mortgage stress test.
Gross debt service
According to Allan Tran, business development manager at credit union Meridian, GDS is the percentage of your pre-tax income needed to pay your home costs. Aside from the stress-tested monthly mortgage payment, your lender will examine the monthly fees of your property, which include taxes or heating cost.
Once you have the sum of all these items, divide that by the amount of your gross monthly pay. "If the ensuing ratio is around 30-32 per cent, most lenders will give you the green light on your mortgage application," said Tran in an interview with Global News.
Total debt service ratio
TDS measures how much of your income will go to paying your debts. Credit cards, car loans and all kinds of debits all make your up your debt payments. Total all of them, and if you want to pass the stress test it should not exceed more than 42% of your pre-tax monthly pay.
Tran warned though that just because you passed the GDS test, doesn’t automatically mean you’ll meet the TDS requirement.
Additionally, reducing your GDS/TDS ratio can increase your borrowing capacity. Here are some ways.
First, you can give a higher down-payment. This way, you can decrease your mortgage debt and your monthly mortgage costs. Second, you can try to increase your gross household income, either by finding additional sources of income or considering a job with a higher salary.
To manage your TDS, on the other hand, try settling your other debts and ensure you keep your loans at bay.
4. It all boils down to your financial capacity.
If you are buying a home on a tight budget, you will be more likely to be restrained by the stress test. Those who use a large chunk of their gross income on housing costs will also be at risk of failing.
Meanwhile, if you are buying a house that is less expensive than your pre-approved budget and should cost you less than 32% of your wage, you can relax a bit because the impact is lesser.
5. This creates opportunities to explore alternative lenders.
Given that the mortgage stress test is becoming a burden to some buyers, this can offer an an opportunity for borrowers to investigate alternative lenders, although some come with higher interest rates.
Because private and smaller lenders don’t rely on funding from banks and do not require stress tests, analysts predict that many potential borrowers will go to these institutions instead.
However, these alternative lenders are more susceptible to raising their interest rates, as well as being more selective in choosing borrowers they lend to.
Overall, the mortgage stress test is a complex process, but once you get the hang of it, you'll realize that can be manageable.
Besides, going through the process can be worth the effort especially at present, with Canadian homes getting more and more expensive. In the recent report of Canadian Real Estate Association, it revealed that the average price of a house in August 2017 was an estimated $472,247, a 3.6% increase from the previous year.
