Applying and qualifying for a mortgage can seem like a pretty intimidating process! When you’re looking to make what will likely be the biggest financial transaction of your lifetime, it’s important that you understand how the mortgage process works and what you can expect to experience as you move through it. The mortgage stress test helps you understand how much mortgage you can afford based on your current financial standing and is a requirement for all Canadian home buyers. Take some time to better understand what it is, how it works and why it’s an important measurement.

What Is The Mortgage Stress Test?

For most Canadians, the interest rates you get access to will have the biggest impact on how much you pay for a home. While there are many other factors that can influence the cost of the home, the mortgage rate will undoubtedly be the main one, especially if you’re looking at a variable mortgage with rates that can increase or decrease depending on bank rates. Because of these rate fluctuations, the Canadian government, through the Minister of Finance and the Office of the Superintendent of Financial Institutions (OSFI), uses the mortgage stress test as a means to assess and mitigate mortgage default risk by setting up a qualifying benchmark.

OFSI sets qualifying stress test rates for uninsured mortgages while the Minister of Finance oversees insured mortgages. It’s important to note that any financial institutions that are not regulated by the federal government don’t have to use the qualifying mortgage stress test but can still apply it voluntarily any time they see fit.

How The Mortgage Stress Test Works

The premise of the mortgage stress test is that you’ll need to qualify for a mortgage using the “minimum qualifying rate.” This rate acts as a benchmark to determine if you can continue to make your monthly mortgage payments when interest rates rise.

The minimum qualifying rate is based on either the benchmark rate of 5.25% or the rate offered by your lender plus 2% – whichever is higher. This means if your lender is offering a rate of 2.99%, you’ll have to use the qualifying rate of 5.25% in your stress test. If your lender is offering a rate of 3.49%, you’ll have to qualify using a rate of 5.49%.

Why Was It Created?

The mortgage stress test helps lenders determine if a borrower can afford their mortgage payments should additional strain be placed on their finances in the future due to rising interest rates. The test and the mortgage qualifying rate were designed to protect the Canadian housing industry, but can sometimes be a roadblock that can force some borrowers to settle for a lower budget or come up with a higher down payment to offset the interest.

Who The Mortgage Stress Test Applies To

If you’re applying for an insured or uninsured mortgage, you will be required to pass this stress test if you’re planning to borrow from any financial institution regulated by the federal government. If you already have a mortgage, you’ll need to face the mortgage stress test should you choose to refinance your home, take out a home equity line of credit or switch to a new lender.

Mortgage Stress Test Qualification Criteria

The mortgage stress test is something that all borrowers in Canada are subjected to when applying for insured and uninsured mortgages through federally regulated lenders. This test helps the lender determine whether a borrower will be able to afford their principal and interest payments should rates increase over time. In order to pass the test, borrowers will need to prove that their income is high enough to support the minimum qualification rate as set out by the government.

Latest Changes To The Mortgage Stress Test

New, more strict rules were put into effect with the mortgage stress test as of June 1, 2021. Originally the mortgage stress test rate was set at the mortgage rate plus 200 basis points – or 2 percentage points – or the Bank of Canada’s 5-year rate of 4.79%, whichever is higher. As of June 2021, the rules have changed and now these new rules apply to both insured and uninsured mortgages (where borrowers have at least a 20% down payment), with the rate having risen to either the mortgage contract rate plus 200 basis points, or 5.25%, whichever is higher. In response, OSFI Finance Minister Chrystia Freeland has said that “Maintaining the health and stability of Canada’s housing market is essential to protecting middle-class families and to Canada’s broader economic recovery.”

How Banks Determine What You Can Afford

When it comes to calculating how much house you can afford, the banks will look at two main criteria. The first is the gross debt service ratio (GDS) which is the percentage of the borrower’s pre-tax income that will cover housing costs like your mortgage, heating/cooling and property taxes. According to the Financial Consumer Agency of Canada (FCAC), your GDS should be no more than 32%, while the Canada Mortgage and Housing Corporation (CMHC) uses the limit of 39%.

The second is total debt service ratio (TDS) which includes any outstanding personal debt like car loans, credit card debt, lines of credit and mortgages. According to FCAC, this should be no more than 40% of your pre-tax income, while CMHC uses the limit of 44%.

Do keep in mind that the amount of your down payment is still a big factor when it comes to buying a home and determining how much house you can afford. Remember that if you’re looking to purchase a home priced at $500,000+, you’ll be required to make at least a 20% down payment to qualify for a mortgage.

Can You Avoid The Mortgage Stress Test?

Since all of Canada’s big banks are regulated by the federal government, there’s no way to avoid the mortgage stress test if you’re applying for an insured mortgage through a lender of any kind. If you’re opting for an uninsured mortgage, lenders that are provincially regulated, as opposed to federally, like credit unions, can use a lower qualification rate than what’s mandated by the test. However, you may be subject to higher rates in exchange for an easier approval, especially if you have a lower credit score.

Deciding what kind of mortgage to apply for and how to best arrange your finances is a big decision. It’s always wise to speak with a specialist and learn more about how to determine the amount of house you can afford without putting yourself in a vulnerable financial position.