What is a mortgage stress test?
Everyone in Ontario applying for a residential mortgage has to pass what is known as a stress test. This is also the case for people who are refinancing their current home with a different lender, as well as those who are seeking a homeowner line of credit.
In a nutshell, a stress test is a method used by lenders to determine if a buyer can qualify for a certain mortgage amount. Because of the fluctuating nature of mortgage rates, the Canadian government sets a minimum qualifying rate at a higher level than the prime rate to evaluate a buyer’s ability to make payments, even if the interest rate goes up.
How exactly does this work? Well, if you go to a lender for a mortgage, you will be offered an interest rate that will apply to that loan. However, it’s important to note that the lender will then use a rate higher than that to assess how much they could approve you for. This is because, since mortgages are for substantial amounts of money, the lender is also trying to assess if there is a risk that you may default on your payments if the interest rate goes up.
In simple terms, the bank or financial institution must evaluate whether you will be able to keep making payments if your mortgage loan becomes more expensive. For example, if you are getting a mortgage at 5.25 per cent, they would typically add two per cent to the calculation and see if you could still manage interest at 7.25 per cent. It’s more complex but that is what the test basically does.
To determine your eligibility the lender will look at several things, including your available down payment, the mortgage amount, current interest rates, the mortgage amortization period, your household income, and any debts you may have. They do this to make two critical calculations:
- Gross debt service (GDS) ratio: the percentage of your income — before deductions — that you will use to pay for things like your mortgage, property tax and utilities.
- Total debt service (TDS) ratio: any debt you may be carrying, such as credit cards, car loans, and student loans.
Rising interest rates are causing the mortgage stress test’s qualifying rate to also increase. Given that the stress test is now harder to pass, then seemingly fewer people will qualify for a mortgage, and the amount they are approved for will also be lower.
If you are in the market for a home and would like to improve your stress test results, try to save as much as possible to increase your down payment, and reduce or clear any debts you may have. This will lower your GDS and TDS ratios and put you in a better position to get approved for a mortgage.
To calculate how big a mortgage you can comfortably afford, I would recommend leveraging online resources, such as the federal government’s mortgage qualifier tool. The Canada Mortgage and Housing Corporation also offers a number of home-buying calculators for mortgages, affordability and debt service that are worth checking out.
For any specific questions, I suggest you speak with a mortgage expert at your bank or financial institution, or a mortgage broker.
Article By: Joe Richer