You’re not the only one that might wonder ‘How much mortgage can I afford?’ when you start thinking about home loans and home buying. Lenders not only want to see the big picture when looking at your mortgage application, but how you might handle payments if there were changes to your finances, including the mortgage interest rate.
Canada’s mortgage stress test is anyone applying for a mortgage or refinancing their home with a federally regulated lender such as one of the major banks and was created to evaluate whether you might be able to afford your mortgage payments should the interest rates increase.
What is a Mortgage Stress Test
A mortgage stress test analyzes your ability to make your payments by looking at your financial information. Lenders will look at many things when reviewing your mortgage application, which can include looking at how likely you can afford the mortgage, costs of homeownership, and the overall cost of living. This is something that all Canadian home buyers are required to pass.
With federally regulated lenders in Canada such as the big banks, this is required. The stress test will look at whether you are able to afford the mortgage payment using the interest rate currently offered to you, as well as a scenario with a higher rate.
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What to Know About a Mortgage Stress Test
The mortgage stress test is actually in your best interest, as it prevents applicants from borrowing more than they could comfortably afford, to ensure that you would be able to continue to afford making your mortgage payments should interest rates go up in the future. Looking at your ability-to-pay, or more commonly known as your debt-to-income ratio, this analysis is composed of two main parts.
Gross Debt Service
First is your Gross Debt Service (GDS), which is your before-tax monthly income. This amount is measured against your mortgage payment, property taxes, utility bills and condo fees, and similar costs that might be applicable. Lenders are looking for a GDS score of 39% or less, which means this is the maximum percent of your monthly income that would go towards housing costs overall. As you might assume, the lower the GDS score the better.
Total Debt Service
Second would be your Total Debt Service (TDS), or the total before-tax monthly income that would be against your housing costs, but also all of your other monthly debt like loans, credit cards and similar. Ideal is a total TDS score of 44% or less would go towards housing costs and debt repayments.
Mortgage Stress Test Rate
As mentioned, a higher rate is also used in these scenarios, and based on your current rate plus 2%. The reason this is done is because mortgage rates are not locked in for the entire term, and usually between 6 months to 10 years. Since rates can change, the point of the stress test is to ensure you would be able to handle your payments should they increase.
The stress test is required of all Canadian home buyers, even if they put 20% down payment or more, and provided through the Minister of Finance and the Office of the Superintendent of Financial Institutions (OSFI) to mitigate mortgage default risk. This test applies to any financial institution regulated by the federal government, such as most big banks. Renewing a mortgage would also require a stress test, if you are switching lenders, or looking to borrow against your home’s equity.
Since the stress test is not the current rate but is based on a higher interest rate, this is what is referred to as the mortgage qualifying rate, and what you need to pass the stress test. So if the current fed rate is 4% then your finances would need to pass the mortgage qualifying rate of 6% for you to pass the test. As mentioned, it’s based on the current rate plus 2%.
How to Pass the Stress Test
To determine what it might take, your gross debt service ratio (GDS) is calculated first. This looks at your pre-tax income along with what it will take to cover housing costs, along with the mortgage, heat and property taxes.
The Financial Consumer Agency of Canada (FCAC) suggests your GDS should be under 32% and the Canada Mortgage and Housing Corporation (CMHC) suggests your GDS should be under 39%. The second aspect is the total debt service ratio (TDS) which includes outstanding personal debt such as loans, mortgage, credit cards, lines of credit and similar. According to FCAC this should be under 40% and according to CMHC the limit is 44%.
Suppose you were applying for a $400,000 mortgage with a household income of $90,000 with a 20% down payment and 5 year rate of 5.75%. When you factor in some monthly costs like heating ($150), property taxes ($200), credit card payments ($100), car payments ($400) then your GDS ratio (31.33%) does not exceed 32.00% and your TDS ratio (38.00%) does not exceed 40.00% and you would likely be approved. It would be important to keep in mind there can be many other costs involved and you want to investigate additional expenses to make sure the payments will fit your budget.
If you were concerned about passing the mortgage stress test you can consider the following as ways that might help.
- Reduce your monthly debt
- Increase your down payment
- Improve your credit score for better interest rates
- Get a co-signer to qualify for a larger mortgage
If you were thinking there must be a way to avoid the mortgage stress test, it exists in your best interest and the banks are mandated to enforce these rules for all mortgage refinance borrowers.
Being prepared for taking on a mortgage is essential when applying. Not only is it possibly the biggest purchase you will make, it can be a complicated process and you should make sure to familiarize yourself with the process and terminology.