Is Canada’s mortgage stress test still relevant?
Earlier this month, the Bank of England scrapped its mortgage affordability stress test.
With mortgage rates now north of 4% and 5%, and presumably approaching their peak for this rate-hike cycle, some are wondering if changes to Canada’s stress test are overdue.
The stress test’s history
The mortgage stress test requires both insured and uninsured mortgage borrowers to prove they can meet monthly mortgage payments based on a rate of 5.25% or two percentage points higher than their contract rate—whichever is higher. These days, borrowers are commonly being stress-test at rates in excess of 6% and 7%.
The stress test for insured mortgages (those with less than a 20% down payment) was first introduced in 2016 by the Department of Finance, while the Office of the Superintendent of Financial Institutions (OSFI) followed with its own in 2018 for uninsured mortgages, or those with a down payment of more than 20%.
They were introduced to address risks the government and the regulator saw as a result of high household debt and high real estate prices, coupled with what were historically low interest rates at the time.
Are changes to the stress test overdue?
Fast-forward to today, and home prices are now dropping across the country from the peak reached earlier this year, while interest rates have risen dramatically as the Bank of Canada tries to curb record inflation not seen since the 1980s.
In today’s context, do the current mortgage stress test rules make sense?
JP Boutros, director of government relations at Mortgage Professionals of Canada, says they’re locking Canadians out of the market. “There was a real good opportunity for people in 2020 and 2021 to get into homeownership with locked, fixed money, but weren’t able to because the stress test was so much higher than the actual available rates,” said Boutros.
Then there’s the issue of variable versus fixed-rate mortgages. The latter offers homeowners more stability on their mortgage payments, but were harder to qualify for until fairly recently: a typical fixed-rate mortgage of 4.45% would be stress-tested at two percentage points higher—so, 6.45%. Richer applicants may not have had a problem with trading extra cash for security, but Boutros says it wasn’t great for less well-to-do homeowners who wanted into the market.
Because of the stress test qualification rules, when fixed rates started rising well ahead of variable rates earlier this year it forced many borrowers into variable rates, simply because that was all they could qualify for.
Data from the Canada Mortgage and Housing Corporation (CMHC) shows over half of mortgages taken out earlier this year (56.9%) were variable-rate products.
“People were shifting to variable-rate mortgages primarily because the stress test was 5.25%,” lower than what comparable fixed-rate mortgages were being stress-tested at, Boutros explained. That changed when the Bank of Canada hiked interest rates by 100 basis points on July 13. Suddenly, variable-rate mortgages seemed a lot less desirable.
As such, some Canadians are turning to B-lenders—alternative lenders that aren’t required to do mortgage stress tests, but often charge significantly higher rates. Others are simply unable to buy a home at all.
Boutros believes the Department of Finance and OSFI should be re-calibrating the exact requirements of the mortgage stress test. “They should have lowered the stress test in 2020 and 2021 to allow for first-time homebuyers to get in and compete with the well-capitalized,” he said of the Canadian government.
But both the Department of Finance Canada and OSFI are keeping their cards close to their chests on any potential changes to the mortgage stress test. In separate statements, they told CMT they “closely watch market conditions and will consider changes as appropriate.”
At least one jurisdiction is doing away with its mortgage stress test altogether. As mentioned above, the Bank of England has scrapped its equivalent of the test, although it does have other qualification guidelines in place still. One of them limits the number of mortgages that can be extended to borrowers with a loan-to-income ratio of 4.5 or more.
Gemma Harle, managing director at Quilter Financial Planning, told the BBC that this restriction generally impacts homebuyers more than the Bank of England’s housing affordability test did.
Given the current housing market situation in Canada, Boutros said it is becoming much harder for new homebuyers to get into the market. He added that it’s also become more challenging for existing homebuyers with a good financial history to lock into a fixed from a variable-rate mortgage, since they have to re-qualify if they’re switching lenders.
“People are going into private mortgages and into B-lenders because some of them have no choice now,” Boutros said. “The stress test is doing that.”