Understanding How The Mortgage Stress Test Rules Work In Canada
When you go to a bank to get a mortgage in Canada, chances are that the mortgage interest rate that is used to qualify your mortgage and the rate you actually pay will differ. The reason for this has to do with something called the mortgage stress test.
Mortgage stress test rules in Canada have been designed to ensure that homebuyers can afford to pay back their mortgages even if interest rates rise in the future. The rules were implemented by the federal government in 2016 and updated in 2021 and are meant to help Canadians maintain their financial stability and prevent them from taking on too much debt. But how does the mortgage stress test work, and when is it necessary?
In this article, I share the mortgage stress test rules (updated for 2023.) I will also give you some tips on how to “pass the test” when applying for your next mortgage loan.
What Is the Mortgage Stress Test in Canada?
The mortgage stress test is a set of rules designed to ensure that you, as a potential or current homeowner, can afford your mortgage even if interest rates were to rise. The test is designed to protect you from taking on a mortgage that’s too big for you.
To pass the mortgage stress test, you must qualify for your mortgage using the “stress-tested” qualifying mortgage interest rate, which is calculated as follows:
How the Mortgage Stress Test Rate Works
When calculating your qualifying mortgage payment under the mortgage stress test rules, your lender must use the higher of 5.25% or your negotiated mortgage rate plus 2%. Note that the qualifying 5.25% interest rate is reviewed by the government each year.
The mortgage stress test doesn’t only apply when you’re buying a new home. You will need to pass the stress test in any of the following scenarios:
- Buying a home
- Refinancing your mortgage loan
- Applying for a home equity line of credit
- Transferring your mortgage to a different lender
- Taking out a second mortgage
What Is the Qualifying Mortgage Interest Rate?
The minimum qualifying rate is the rate the lender must use to determine your mortgage payments and your overall affordability. It’s not the rate you will actually pay on the mortgage, although it could be. Currently, the qualifying mortgage interest rate is 5.25% or your negotiated rate + 2%, whichever is higher.
How Does the Mortgage Stress Test Reduce Risk?
For years, Canadian homebuyers enjoyed rock-bottom interest rates. Before the Bank of Canada began raising its policy interest rate in 2022, you could get a 5-year fixed mortgage rate as low as 1.5%.
The problem is that if your maximum affordable mortgage payment is calculated using a 1.5% interest rate, what happens when you have to renew your mortgage five years later, and the rate has jumped to 6% or more? Your payments would suddenly skyrocket, and unless your cash flow has improved significantly during that five-year period, you may no longer be able to afford your mortgage payments.
By forcing lenders to use a much higher qualifying rate, the mortgage stress test ensures that the home buyer can still afford the mortgage during a higher interest rate environment.
This scenario is precisely what’s happened in 2023. Mortgage rates have increased approximately 5% over the previous 18 months, making housing less affordable across Canada.
How Is the Canadian Mortgage Stress Test Calculated?
Mortgage stress test rules determine the mortgage interest rate that will be used for debt servicing purposes (GDS and TDS). While it’s unrealistic in the current environment, let’s say you manage to negotiate a mortgage rate of 3%. The rate that financial institutions will use to calculate your mortgage payment will be the qualifying rate of 5.25% and not 3%.
The resulting mortgage payment is then considered with other factors, like income and debt payments. For example, the higher your income, the higher the mortgage payment you can presumably afford. On the other hand, if you have a $800 monthly car loan payment or substantial credit card debt, it will lower your affordability.
How To Pass The Mortgage Stress Test
Generally, the mortgage stress test rules reduce the mortgage amount you qualify for. This means that you may not be able to afford the home you were hoping to buy. Here are some things you can do to improve your affordability and pass the mortgage stress test.
- Increase your down payment: The more money you save on your own, the less you have to borrow. By paying more than the minimum down payment, you can apply for a smaller mortgage, which means a smaller monthly mortgage payment.
- Buy less home than you can afford: One of the biggest problems people run into is buying more home than they can afford. The mortgage stress test rules help to prevent this, but you can make it easier on yourself by purchasing a home that is well within your budget, regardless of the mortgage interest rate.
- Reduce your overall debt level: When you apply for a mortgage, the lender must consider the total debt payments you make each month when assessing your affordability. If you can pay off credit cards or loans, or avoid taking out additional debt, it will improve your mortgage affordability.
Does the Mortgage Stress Test Apply to Mortgage Renewals?
The current mortgage rules do not apply to mortgage renewals if you plan on staying with your current lender. However, if you decide to switch lenders or if you wish to refinance your mortgage when you renew, then you will likely have to undergo the stress test.
Is There a Stress Test for Conventional Mortgages?
Conventional mortgages are included under the new mortgage stress test rules. This means that even if your mortgage is uninsured with a down payment of 20% or more, as long as your lender is subject to the stress test rules, then they will apply.
As mentioned, the stress test rate is calculated as the higher of 5.25% or your negotiated mortgage rate plus 2%. However, if you choose to renew your mortgage with your current lender, they are not required to apply the stress test.
Can I Avoid The Mortgage Stress Test?
The only way to avoid the mortgage stress test is by getting your mortgage through a lender who is not required to follow stress test rules and hasn’t implemented their own stress test. This may include some credit unions, alternative lenders, and private mortgage lenders. You would want to check with your lender about their policy before you proceed with any mortgage application.
What is the history of mortgage stress tests in Canada?
The mortgage stress test was introduced by the federal government in 2016, but the rules were updated in 2021. The purpose of the stress test is to ensure that potential and current homeowners can afford their monthly payment, even in case of a job loss, income reduction, or an interest rate spike.
How do CMHC stress tests differ from others?
Canada Mortgage and Housing Corporation (CMHC) stress tests are specifically for insured mortgages, which are mortgages with a down payment of less than 20%. Uninsured mortgages, with a down payment of 20% or greater, may have different stress test rates depending on the lending institution.
What income do you need to qualify for a 500k house?
To determine the income required to qualify for a 500k house, you’ll need to consider various factors such as interest rates, the amount of your down payment and property taxes, your overall debt levels, and the length of your mortgage amortization. Lenders will look at your gross debt service (GDS) ratio and total debt service (TDS) ratio to ensure that you can manage your housing costs without financial strain.
Do all mortgages in Canada require a stress test?
Anyone who gets a mortgage from a federally regulated mortgage lender must pass a mortgage stress test when applying for their mortgage loan. This includes CMHC-insured and conventional mortgages.