Signing a mortgage is usually the largest financial commitment many Canadians make, and in todays rising rate environment that can come with some significant risks. Following the steepest Bank of Canada rake hikes in history over the last year and a half, mortgage payments have increased faster than anyone would have imagined.
The mortgage stress test was introduced in order to help mortgagees be prepared for the worst when it comes to rising rates and eroding affordability.
The term stress test comes from the finance industry and was designed to address a negative scenario that might occur in the future.
A mortgage stress test is a way of determining exactly how much you can afford (and under what circumstances) If your income was reduced or you lost your job, would you be able to still make mortgage payments? Whet if interest rates increased and you needed to renegotiate your mortgage?
This type of rainy day planning is very important as we have seen 5 year fixed and 5 year variable rates increase from lows of 1.39% and 0.85% respectively during 2021 to 5.54% and 5.68% as of December 2023.
So how does the mortgage stress test work?
When you apply for a mortgage you will be offered a contract rate, either by your financial institution or a mortgage broker. Either one of these individuals will need to determine if you will be able to repay this loan. To do this they will check on the requirements provided by the Office of the Superintendent of Financial Institutions (OSFI) which is based on the mode average of posted 5 year fixed rates from Canada’s big banks, or your contracted rate plus 2%, whichever is higher.
This means that your income needs to be high enough and your existing debt low enough ,that you will be able to pay down your mortgage at the higher rate. This process usually means you will only be able to borrow a smaller amount of money than you might have been able to if the stress test had not been calculated to determine your final and agreed to mortgage amount.
As you may be aware, a number of properties in the United States fell into foreclosure a few years ago, and this was in part by Buyers not qualifying for future mortgage payments and not having read the fine print on their mortgage agreement. The Canadian stress test was introduced in an effort to ensure the type of upheaval that was created by this scenario in the U.S. both in the real estate and financial industries, did not happen here in Canada.