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 use a rate higher than that to assess how much they could approve you for. This is because a mortgage is a loan for a substantial amount of money and the lender is trying to assess if there is a risk that you may default on your payment if the interest rate goes up.
In simple terms, they essentially evaluate whether you will be able to keep making payments if interest rates go up to a certain level. For example, if you are getting a mortgage at 5 per cent, they might see if you could manage interest at 7 per cent. Although it’s more complex, that is what the test basically does.
To determine your eligibility the lender will look at several things, including the 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 stress test’s qualifying rate for a mortgage to increase. Given that the stress test is now harder to pass, it is likely that 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 homebuying calculators for mortgages, affordability and debt service that are worth checking out.
For any specific questions, I would suggest speaking with a financial expert or mortgage broker.
If you have a question for Joe about the home buying or selling process, please email firstname.lastname@example.org.
This column is for general information purposes only and is not meant as legal or professional advice on real estate transactions.Joseph Richer is Registrar of the Real Estate Council of Ontario (RECO). He is in charge of the administration and enforcement of all rules that govern real estate professionals in Ontario. You can find more tips at reco.on.ca, follow on Twitter @RECOhelps or on YouTube at http://www.youtube.com/RECOhelps.