Impact of Stress test on the Canadian first time home buyers

The Office of the Superintendent of Financial Institutions (OSFI) has proposed a hike in the qualifying rate for uninsured mortgages - the stress test to be faced by homebuyers.

The increasing qualifying rate is the step to ensure that borrowers can pay mortgages at a higher rate of interest if it still rises further.

This step will make it harder for borrowers to qualify for a home loan.

Top banking regulator proposal

Canada's top banking regulator has proposed an increase in the mortgage stress test level at the contracted rate plus 2% points above the market rate, or 5.25%, which is higher.

This is the hike from the previous 4.79%, Canada's Five-year benchmark rate, and the biggest lenders' average posted rate.

What is the mortgage stress test?

A mortgage stress test is a method to ensure how much borrowers can afford if their income is reduced or the job is lost.

Starting in 2018, the stress test applies to all Canadian home buyers who apply for a mortgage from a federally regulated lender. Borrowers who have paid at least 20% as a down payment have to undergo the OSFI mortgage stress test.

The stress test will scrutinize the finances of the borrower before they gain mortgage approval from the lender.

New rule as per the stress test

According to the proposal, any home buyer whose down payment on the home is lower than 1/5 of the purchase price would have to undergo the stress test, which will ascertain their capacity to afford the mortgage payments stuck by a higher interest rate environment.

The step is initiated to increase the margin of safety for borrowers in the post-pandemic scenario.

For instance, The Bank of Canada's five-year benchmark rate is 5.19%, and if you apply for a mortgage rate of 3.65%, the lender can assess you for paying your home loan at 5.65% (3.65% +2%) Since 5.65% is greater than the Bank of Canada's five-year benchmark rate.

In the current market, the interest rates have hit rock bottom. There is a continuous increase in the demand for homes, but against it, the home supply is limited. This has led to home prices shooting up. To control price hikes, the federal government and regulators tighten housing market rules so that the market can be cooled off.

According to OSFI, housing market conditions currently are making lenders vulnerable to financial risk. The increased qualifying rate would add to the safety margin, ensuring borrowers can pay back mortgage payments if the interest rate further rises.

The new stress test rule has made it difficult for homeowners to refinance or renew their mortgages.

Current lowest mortgage rates

Bank of Canada is keen on keeping the interest rate nearly zero until 2023. However, officially known as B-20 guidelines, the stress test will test potential homebuyers' financial feasibility - if they would be able to make mortgage payments should the interest rate rise much higher than what it was at the time of signing up for the mortgage.

Comment from the superintendent Jeremy Rudin

Talking to reporters, superintendent Jeremy Rudin suggested a need to make the economy ready to return to a pre-pandemic condition where the interest rate was much higher than the current market.

Currently, the market rates are extraordinarily low, which is the temporary scenario.

The stress test would ensure that lenders are protected, and buyers can repay debts. This will ensure the stability of the financial system of the economy.

Impact of the stress test

According to James Laird, co-founder of and President of the mortgage brokerage CanWise financial, the proposal will make it difficult for first-time homebuyers to qualify for a mortgage. However, it will help homebuyers in the long run if the policy positively affects lowering home value hikes.

The stress test would curtail the number of qualified borrowers, thus bringing down the country's home prices. The home buyers purchasing power will be about 5% once the stress test is applicable from June 1, 2021.

The regulators are seeking submission from stakeholders regarding the proposal until May 7.

Moreover, 0SFI is also planning to revisit the qualifying rate's calibration at least once a year to ensure it remains conducive to the environmental risk.

Now that the Canadian condo prices have increased by 25% in the year until the end of February, the stress test ensures lenders are not at greater financial risk.

Stress test - To tackle the house debt issue in Canada

The stress test is designed for the federally regulated bank, but mortgage lenders such as credit unions and private lenders are not under OSFI jurisdiction. They are not required to put their mortgage applicants through a stress test.

The new measure is aimed at financial stability; however, it is doubtful that it will cool down the housing market.

Homebuyers should act fast

According to the proposal, uninsured borrowers' purchasing power will reduce by 4% to 4.5%.

The maximum amount that borrowers can procure under the new rule would decrease by 4.5% (from $442K to $422k for median income households).

How does a stress test impact first-time homebuyers?

Stress test makes it tougher for first-time homebuyers because now they can borrow less than what was expected. Now they have to re-think their purchase or have to settle for another inexpensive home as their purchasing power is lowered.

If you are also planning to buy a condo in Toronto, today is the time for purchase (before June 1, 2021), as the stress test will negatively affect existing borrowers.

If borrowers fail the stress test, they will not be able to purchase a home at better rates and would have to continue with the current lender.

To pass the stress test, a borrower has to increase their liquidity, which means they have to indulge in larger savings, smaller debt obligations, and lower any unforeseen financial downturn.

How can you improve your chances of passing the stress test?

To pass the stress test, the highest levered options are:

1) Reduce your debt obligations

By paying off or reducing your outstanding debt balances, you can decrease your debt and improve your TDS ratio. Also, try consolidating your debts using a lower interest borrowing source to repay high-interest debt first.

2) Increase your income

Increase your income to improve your affordability for a larger mortgage.

3) Apply with co-applicant

If you apply with the co-applicant, it improves the overall income level used in the stress test. The co-applicant on a mortgage can be your spouse, partner, or family member.

4) Increase your down payment

With the increase in the down payment, you will decrease the mortgage payment, which will lower your housing cost.

If you are also worried by the concern of not passing the mortgage stress test, there are many other options for home buying that you can explore in Toronto like:

1) Credit unions

These are not required to do the stress test as they are not regulated federally.

2) Private lenders

Reach out to private lenders as they are willing to lend the funds to finance your home purchase. However, they will charge for the higher interest rate coupled with short payback terms.

3) Consult a mortgage broker

Sometimes mortgage brokers can help you find out the mortgage lender apt for your current circumstances.

4) Choose a more affordable property

It's better to consider buying a home in an affordable real estate market so that you do not need to pass the stress test.

5) Reach out to the mortgage finance companies

Mortgage finance companies or monoline mortgage lenders specialize in mortgages, and they do not require a stress test.

Meet your expert property consultant

For expert advice on home/condo buying in Toronto, reach out to DAVID HUTCHINSON now, or the enforcement of stress tests might make the dream of home buying more difficult than ever.