According to the Bank of Canada, as of 2018, 10% of prospective home buyers may not get approved for mortgages. Mortgage Professionals Canada puts that number even higher at 18%. Why the sudden change? The new mortgage stress test is coming into effect in 2018, and analysts say it will make mortgages harder to get. Of course, that’s exactly why the Office of the Superintendent of Financial Institutions put the stress test into place, not to make mortgages harder to obtain, per se, but to reduce foreclosures and the inability to pay. In either case, your clients are likely to have questions, and here’s what you need to know to advise them.
How the Mortgage Stress Test Works
The mortgage stress test is pretty straightforward. When reviewing applications, loan officers have to consider whether borrowers can afford a higher interest rate. In particular, lenders need to look at the higher of the five-year benchmark rate or the borrower’s approved rate plus two points.
For example, if someone is taking out a mortgage with a 4% interest rate, he needs to be able to afford a 6% interest rate. In contrast, if someone is looking at a mortgage with a 2% interest rate, that bumps it up to 4%, but as the benchmark rate is 4.89% as of 2018, that person needs to be able to afford the 4.89 rate instead.
In addition to passing the stress test, borrowers must also meet other criteria when taking out a mortgage, and if your clients are thinking about homeownership, you may want to talk with them about these requirements as well. At a maximum, they can only spend up to 32% of their income on housing costs. That takes into account the mortgage but also the utilities and property taxes.
On top of that, their total debt-to-income ratio must be less than 44%. That ratio divides their housing payments, car payments, credit card payments, and any other debts by their income. Consider helping your clients crunch the numbers before they apply so they know what to expect.
Who Is Affected by the Mortgage Stress Test?
The stress test only applies to borrowers who have at least a 20% downpayment. To explain, if someone is buying a $300,000 house and has $60,000 or more for the downpayment, he has to pass the stress test. If the downpayment is smaller than that, there is an existing set of rules that applies, and in fact, those existing rules are practically identical to the new rules. The only change is the shift to focus on borrowers with larger downpayments.
The test also only affects people who are taking out loans from federally regulated lenders. If someone is buying a home with owner financing or going through a credit union, he doesn’t have to worry about the stress test. Additionally, if he wants to refinance the mortgage, he definitely has to pass the stress test to work with a new lender, but if he stays with the existing lender, he may not have to pass the stress test. It’s up to the lender.
Areas Most Likely To Be Affected
When analysts from the Bank of Canada estimated how many people wouldn’t be able to get mortgages, they looked at mortgages that had been approved in the last few years before the new rules went into effect, and they found that $15 billion in mortgage loans would not have been funded. Roughly two-thirds, or $10 billion, of these loans were based in Toronto and Vancouver. As a result, those are the two areas most likely to be affected.
The Purpose of the Stress Test
The purpose of a stress test is to see how something functions under stress. In this case, the mortgage stress test makes sure borrowers can withstand the stress of an interest increase. Indirectly, the test also determines if borrowers are likely to be able to cover their mortgage payments if they incur other unexpected bills or experience an income reduction. Effectively, the stress test reduces borrowers’ buying capacity by about 18.5%. If a buyer would have been approved for a $400,000 mortgage under the old rules, he’d likely qualify for a $326,000 mortgage under the new rules.
In some cases, the reduction in buying power can be even higher. It depends on the interest rate offered with the loan and the current benchmark rate.
Potential Ancillary Effects
The mortgage stress test should reduce missed payments and foreclosures, but it’s also likely to have a broader effect. In areas such as Toronto and Vancouver, the stress test is going to reduce demand as it weeds out certain borrowers. That, in turn, is likely to bring down house prices in those areas and hopefully bring them more in line with wages.
Buying a home is a joyous occasion for most people, and if you have clients who are anticipating a tax refund, they may even want to put that money toward a downpayment on their own home or on an investment property. However, the OSFI stress test makes this process a bit more challenging. Talk with your clients before they apply so they know what to expect.