It's hard to ignore the headlines in the media in regards to the impending Canadian Mortgage Stress Test - to be implemented on January 1, 2018.
You're not alone if your first thought was that this test meant to measure the psychological pressures of carrying the astronomical financing that's required to own property in Canada's red-hot real estate market.
But, no the stress test isn't a head examination. It's meant to test your ability to carry financing in higher-than-now-interest rate conditions. In other words, the government believes it's prudent that banks check to see that, should the interest rates rise, you would still be able to handle the money you've borrowed from them.
This article is meant to simplify the meaning and intention of Canada's Mortgage Stress Test (eliminating overly complicated financial jargon). In addition, I'll explore who might be impacted and how, and finally an optimistic perspective being largely ignored through various media channels.
I conducted a phone interview with D'Arcy Henneberry of MortgagePal.ca to gain his perspective on the stress test and to have him explain it to me in a way a layman could understand it. The answers written below aren't verbatim - they're my interpretation of D'Arcy's explanation and therefore should not be taken as any form of professional advice. If, however, you'd like to seek answers to mortgage-related questions, it's best you speak with D'Arcy directly - you can connect with him at email@example.com or (604) 992-7323.
What is the Mortgage Stress Test?
When applying for a mortgage, a lender will simulate a borrower's financial circumstances by qualifying them at the higher of either, the benchmark rate (explained below) or 2% higher than the rate being offered by the bank.
The benchmark rate is a qualifying rate set by the Bank of Canada and is comprised of an average of the 'posted 5 year fixed' rates used by Canada's six major banks.
Put simply, the lender will use the Stress Test to ensure that the borrower could still make payments on the borrowed funds should the interest rates begin to rise.
What is the Purpose of the Stress Test?
Since 2009, there has been a continuous threat of rising rates. In the last year, the rates have risen slightly. As such, the stress test is a cautionary measure implemented by the Government of Canada to ensure that, should rates rise during the term of a mortgage, or upon renewal, that the borrower could manage an increase.
Why do Mortgage Interest Rates Rise?
The cause of rising interest rates varies between the two types of interest rates - fixed and variable.
Variable interest rates are directly impacted by a combination of the overnight lending rate (set by the Bank of Canada) and the prime rate (set independently by individual banks).
Fixed interest rates are more closely tied to the bond market. If bond yields rise, fixed rates follow suit, followed next by the variable rates.
Why is the Introduction of Canada's Mortgage Stress Test Significant? Should everyone care?
The stress test is significant because qualifying borrowers at higher rates will reduce the amount they're able to borrow. It will impact their purchasing power by 20 to 25% and has the potential to eliminate entry-level buyers.
To make this simple to understand, let's consider an example. To do this comparison I used a really useful calculator on MCAP's website (a popular wholesale lender for D'Arcy). I left the default numbers in place which weren't totally realistic ($150 for housing costs and $450 for liabilities) but the shift in affordability is still evident.
At a current rate, a borrower earning $4,000, could borrow $232,339 at 3.5% amortized (to be paid back) over 25 years. Of course, there is more detail here including the expenses and liabilities as depicted in the screenshot below.
After being measure against the stress test though (increasing the interest rate from 3.5% to 5.5%, the same borrower could only borrow $190,042.
So, even though you could afford $232K, now, the lender can only offer you a maximum of $190K - in this case, the borrowing power is reduced by $40K.
If you're looking to borrow, or currently have a mortgage - you could be required to undergo the Stress Test as of January 1, 2018. To explain who will be impacted, you first need to understand a bit of history…
Prior to October 2017, a mortgage had two classifications - the first, known as 'Conventional' included those mortgages with 20% or more (of the purchase price) as a down payment. The second, known as 'High Ratio' included mortgages with less than 20% as a down payment including the requirement to carry default insurance (for the benefit of the lender).
Mortgages with less than 20% as a down payment are termed 'High Ratio' because the financing (or borrowed money), when compared to the equity (money saved), is more highly skewed towards financing. The reason for the distinction between these two types of mortgages is that High Ratio borrowers the insurer with a higher risk should they default (or fail to pay) their mortgage payments.
To make this easy to understand, imagine you purchase a $300,000 property and put $15,000 down as your down payment (5% of the purchase price) and have therefore mortgaged $285,000. In the event, the real estate market dipped more than 5% and you failed to make your payments, the lender would foreclose on the property - subsequently selling the property to recoup all of the mortgaged money.
Because of the dip in the real estate market, the home that you originally bought for $300,000 is now only worth $270,000. And, perhaps you've lived here for a while, so you've paid down some of the original mortgage (or principle). Perhaps, rather than owing the original $285,000, you now owe $280,000.
As you can see, the bank needs $280,000 repaid, but the home value is only worth $270,000 - the bank faces a $10,000 loss.
For this reason, High Ratio lending requires the borrower to have (and pay for) costly mortgage loan insurance. The insurance covers any loss that a lender would incur as a result of a mortgage default. Mortgage loan insurance is offered by - Genworth, CMHC, and Canada Gauranty.
Note: I've written another article on mortgages which details the premiums payable - you can read more on that here.
To re-cap - pre-October 2017 there were two types of borrowers. Conventional with 20% down or more and not required to have default insurance, and High Ratio borrowers - those with less than 20% down and were required to have insurance, which was paid for by the borrower.
As of January 1, 2018, rather than two types of mortgages, there will be three. They are:
An Insured Mortgage is one where the client pays for default insurance no matter the amount of their down payment amount. In other words, a Buyer can put as much as 35% down and they (not the lender) pay for the insurance. One would elect to purchase default insurance as a lender will offer a lower rate due to the added security by way of insurance.
An Insurable Mortgage is one with 20% or more as a down payment and insurance that is paid for by the lender. This mortgage type would have the next best available interest rate.
An Uninsurable Mortgage is ineligible for insurance. Some examples include properties priced over 1 million dollars, mortgages having an amortization (mortgage repayment term) of more than 25 years. And, rental properties that only have one unit. A refinance is also uninsurable. Uninsurable mortgages have the highest interest rates as the lender absorbs the highest degree of risk.
So, under the new rules, borrowers would be stress tested at either the five-year benchmark rate (as discussed at the beginning of this article), or two percent higher than their actual mortgage rate — whichever one is higher.
Are there borrowers who won't undergo the stress test?
For those who currently have a mortgage and look to renew with the same lender - the stress test may not be required. If however, your mortgage is up for renewal and you elect to switch lenders - you'd then be required to undergo the stress test. And, if you try to refinance your home (taking equity out - borrowing more), you'd also be required to undergo the stress test.
Is there any Good News?
D'Arcy believes it's always easiest to picture gloom and doom with change as change is uncomfortable and unknown. However, D'Arcy explained that only federally regulated lenders will be required to conduct the stress test.
There are three types of lenders - banks, credit unions, and monoline lenders. Monoline lenders, for those who are unfamiliar, are businesses who only provide mortgage financing - they don't do anything else, unlike banks and credit unions.
Interestingly enough, both banks and monoline lenders are federally regulated - therefore having to abide by the stress test. Credit unions, on the other hand, are provincially regulated, meaning that won't have to comply.
D'Arcy was quick to suggest that it doesn't mean credit unions won't follow suit - it just means that they don't necessarily have to.
This might be a good opportunity for credit unions to capture the offspin from the federally regulated monoline lenders and banks.
It is interesting that numerous news articles speak to the potential impact of the stress test while failing to mention the difference in lender regulations.
Here's an article detailing why credit unions may be a good option for those looking to skirt the stress test.
What Might Federally Regulated Lenders do to Offset the Impact of the Stress Test?
While it's legal to provide a 35 year amortization periods - therefore shrinking mortgage payments, D'Arcy only has one lender who's currently offering this. Once the stress test is in effect, there could be a movement back towards longer amortization periods.
THE BOTTOM LINE
With any regulatory change, the media are quick to rush to headlines of gloom and doom. While an adjustment period is likely, eventually the required stress test will become the new norm. If you're looking to renew your mortgage, curious about a new mortgage, or have questions in general - reach out to D'Arcy - he'd be happy to help you.
P: (604) 992-7323
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