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Canadian mortgage stress test is important for everyone to know who either bought a house years ago or thinking of buying in the next couple of years. You are less likely to get a mortgage from a bank if you, as a homebuyer, don’t know about the mortgage stress test. So, continue reading as you are about to know what the Canadian mortgage stress test is and how you can qualify for it.
What is the Canadian Mortgage Stress Test?
Coming into effect in 2018, this test came from the Office of the Superintendent of Financial Institutions (OFSI) with a purpose to ensure Canadians spend what they can afford on mortgages. This test plays a vital role to qualify for a mortgage from a bank. In simple words, it is a surety that a homebuyer can afford a mortgage at a qualifying rate.
When anyone applies for a mortgage from a federally regulated lender, you will be required to undergo the OSFI Mortgage Stress Test, including the ones who put at least 20% as a down payment.
In financial terms, a stress test is just how it sounds. It is a defined way of testing how you and your finances might be affected by a sudden jolt of financial turmoil, like loss of employment and a medical emergency. A stress test will figure out how you will cope with the financial hurdles as a potential homeowner.
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Purpose of Stress Test
Stress test aims to tackle the household debt issue in Canada and prevent consumers from getting themselves into even more debt by taking on a mortgage that’s too big for them. As a fact, the average household debt in Canada is indebted at 170% of their disposable income, which means Canadians owe $1.70 for every dollar they earn after taxes. Moreover, seeing the current rise of housing and interest rate, it will be almost impossible for homeowners to afford the houses in the foreseeable future.
This stress test was initially for the people who applied for high-ratio mortgages – who were not making more than a 20% down payment. The test also included homeowners with a mortgage term of fewer than 5 years. However, now all candidates even those applying for a conventional mortgage will have to take the test. This new amendment applies to both new and current borrowers, taking effect from January 1st, 2018.
How does the Canadian mortgage stress test work?
Once you apply for a mortgage, the bank will determine the interest rate on your credit score. Under the stress test, this interest rate will not be used by the lender. Rather, you will be offered a considerably higher interest rate. This way, the stress test will know whether you will afford the mortgage, if the interest rate goes high in the future.
To give you a number, know that the rate offered by your lender will add 2% more interest. So, for instance, if it was offering 4.79% interest, now it will be 5.25% under the stress test.
To understand it better, take the case study of a borrower John. John applied for a mortgage worth $400,000 in order to buy his house. Considering the credit score, the monthly payment was determined at $2,385 under the stress test. If John had made his decision of taking the mortgage early and would have applied for it before 2018, the mortgage monthly payment would be $1,650 only.
Now, once you know what the Canadian Mortgage Stress Test is and how it works, it is time to move onto the next important part of how you can prepare for it.
How to Prepare for Mortgage Stress Test?
Although there is not much that you can do about the rate you will get from your lender and your stress test rate, it can help to have a basic understanding of where you stand before you apply. In the most ideal case, you should talk to a mortgage broker or a real estate agent about it.
For better preparation, here are a few key metrics that are considered to test how much stress a borrower can bear.
Gross debt service ratio (GDS):
GDS represents the percentage of pre-tax income that is required to pay all housing costs. The lender not only looks at the stress-tested monthly mortgage payment but also the cost of all other monthly expenses such as condo fees, property taxes, and utility bills. These costs are then added together and divide by the gross monthly income. The percentage, however, should not be more than 32%.
Total debt service ratio (TDS):
The debts you already owe are also included in the stress test. That is why lenders also look at your total debt. TDS represents how much of your monthly income is needed to cover your debts.
These debts can include but are not limited to car payments, personal loans, student loans, credit cards, lines of credit, etc. After adding all the debts, the percentage should not be more than 42% of your gross monthly pay.
If it exceeds 42%, your mortgage will not be approved. But don’t worry if this is the case. You can follow the below steps to rectify this.
How To Prepare for Mortgage Stress Test?
Pay Your Debt: As mentioned already, debt is the most important factor in determining your eligibility. If you have a pile of debt on your head, your TDS will be high, and chances of approval will be low. However, if you pay down your current debt, TDS will be low and you will get approved instantly.
While paying debt, try to get rid of high-interest debt first like credit cards. Taking this step can make the stress test more favorable for you.
Apply for a smaller loan: Be realistic about how much money you can pay for a house. It will be unwise to go for an $800,000 house when you can only afford a house worth the $600,000 range.
Taking a high loan will increase the odds for you no matter how financially strong you are. In contrast, if you go for a smaller loan amount, your passing the stress test will be easier. Moreover, it will also free up more of your income and prevent you from becoming poor.
Analyze Your Future Finances: The first question you should ask yourself is whether you can afford to pay an additional $500 if the rates of the mortgage go high. This question is a must-ask especially if you are applying for a variable mortgage.
So, if you are asked to pay an additional $500 every month, would that be doable for you? Or it will put you into a financial decline? That is exactly the reason why the stress test is implemented.
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Canadian Stress Test Alternative
If you find yourself at odds and unable to qualify for the mortgage based on the stress test, there is an alternative for you. Go for the special mortgage programs. You can also save for a bigger down payment or choose a lower-priced home.
A stress test might not fit well for many potential buyers as it makes the mortgage process tougher than it ever was. So, if you are unable to make it through, keep your heart as many will also fail at this. Your goal should be to get the best for yourself no matter if it is under stress test or not.
The Bottom Line
At Lionsgate, we specialize in helping people obtain funding private mortgages for land purchases as well as for other real estate transactions. If you are looking to get a mortgage for your house, leave us a message and we will try to connect you with the best realtors to get you what you need.