In recent years, Canada’s real estate market has experienced rapid growth, leading the government to introduce measures aimed at ensuring that homebuyers are financially prepared for fluctuations in interest rates. One such measure is the mortgage stress test, a crucial step in the mortgage approval process. This guide will walk you through how the stress test works, who it applies to, and how to navigate it successfully.
What Is the Mortgage Stress Test?
The mortgage stress test is a set of financial rules designed to determine whether homebuyers can afford their mortgage payments if interest rates rise in the future. The test ensures that borrowers can handle an increase in rates, thereby minimizing the risk of default.
Implemented by the Office of the Superintendent of Financial Institutions (OSFI), the stress test applies to both insured and uninsured mortgages, effectively setting a safety buffer for mortgage affordability in Canada.
How the Mortgage Stress Test Works
The mortgage stress test examines whether borrowers can afford mortgage payments at either:
- The Bank of Canada’s five-year benchmark rate (currently higher than typical contract rates).
- Your contract rate plus 2%.
The higher of these two rates is used in the test. For example, if your contract rate is 4%, the stress test will check whether you can afford mortgage payments at 6% (4% + 2%).
Here’s a breakdown of how the mortgage stress test calculation works:
| Scenario | Current Mortgage Rate | Stress-Tested Rate |
|---|---|---|
| Bank of Canada benchmark rate | 5.25% | 5.25% |
| Contract rate | 4.00% | 6.00% |
| Contract rate (low) | 2.50% | 4.50% |
In this case, the stress-tested rate is 6% (the higher of the two). If your financial profile shows that you can afford payments at this rate, you’ll pass the test.
Example Calculation:
Suppose you’re applying for a $400,000 mortgage with a 25-year amortization period and a contract rate of 4%. Without the stress test, your monthly mortgage payment would be calculated as follows:
- Monthly payment (contract rate): $2,108
However, using the stress-tested rate of 6%, your new monthly payment would be:
- Monthly payment (stress-tested rate): $2,559
To pass the stress test, you must demonstrate the ability to afford the higher monthly payment of $2,559.
When Do You Need To Be Stress-Tested?
The mortgage stress test applies under various circumstances:
- New Mortgage Applicants: Whether you’re purchasing your first home or upgrading to a new one, the stress test is mandatory.
- Mortgage Renewals: If you renew your mortgage with a different lender, you’ll need to undergo the stress test again. Renewing with the same lender usually doesn’t require a new stress test.
- Refinancing: If you’re refinancing your mortgage to access home equity, the stress test will be applied based on your new mortgage terms.
What If You Fail the Mortgage Stress Test?
Failing the mortgage stress test can be frustrating, but it doesn’t mean that homeownership is out of reach. Here’s what happens next:
- Lower your borrowing amount: Failing the test indicates that you’re applying for a mortgage amount that exceeds what you can afford. Consider lowering the amount you’re trying to borrow or increasing your down payment.
- Adjust your expectations: Sometimes failing the stress test means you may need to reconsider your homebuying options, perhaps focusing on smaller or more affordable homes.
- Improve your financial profile: Work on improving your credit score, increasing your income, or reducing debt to better position yourself for approval.
How To Avoid the Mortgage Stress Test
While you can’t entirely avoid the stress test if you’re applying for a new mortgage or refinancing, there are strategies to minimize its impact:
- Increase your down payment: A higher down payment reduces the amount you need to borrow, improving your chances of passing the test.
- Choose a shorter amortization period: A shorter amortization period increases your monthly payments but lowers the overall interest burden, making it easier to pass the stress test.
- Improve your debt-to-income ratio: Pay down outstanding debts to improve your financial profile before applying for a mortgage.
- Negotiate a lower interest rate: While the stress test adds 2% to your contract rate, a lower base rate can soften the impact.
The Bottom Line
The mortgage stress test is an essential tool to protect borrowers from financial strain due to fluctuating interest rates. Understanding how it works and planning your finances accordingly will give you the best chance of passing. Whether you’re a first-time homebuyer or refinancing an existing mortgage, ensuring your financial stability by passing the stress test will set you on a path toward successful homeownership. Read more here
Frequently Asked Questions (FAQs)
1. What is the minimum interest rate for the mortgage stress test in 2024?
As of 2024, the Bank of Canada’s benchmark rate is 5.25%, but this can change depending on market conditions. Your lender will use the higher of either the benchmark rate or your contract rate plus 2%.
2. Can I bypass the mortgage stress test?
No, the stress test is mandatory for all new mortgage applicants and those refinancing or switching lenders. However, renewing with the same lender usually doesn’t require re-testing.
3. Can self-employed individuals pass the stress test?
Yes, self-employed individuals can pass the stress test, but they may need to provide additional documentation, such as tax returns, to verify income.
4. Does the stress test apply to variable-rate mortgages?
Yes, the stress test applies to both fixed and variable-rate mortgages. Even if you choose a variable-rate mortgage, you’ll be stress-tested at the higher of the Bank of Canada’s benchmark rate or your contract rate plus 2%.
5. Can I improve my chances of passing the mortgage stress test?
Yes, you can improve your chances by increasing your down payment, reducing debt, or boosting your income. Improving your credit score and choosing a shorter amortization period may also help.
