Navigating stress tests and high-ratio mortgage insurance
As if the real estate market weren’t already challenging enough, the government has decided to make it even tougher by tightening the qualification thresholds for certain mortgages. If you’re applying for a mortgage through a federally-regulated financial institution, you need to pass a “stress test” to qualify for a mortgage. In other words, you have to show you can meet mortgage payments at a specified rate that’s higher than the current prevailing rate of the mortgage you’re applying for. Here’s what you need to know.
This sometimes comes as a shock to new home buyers who are also applying for mortgage loan insurance and think they’ve already dotted all the i’s and crossed the t’s in their budget. It comes as an even bigger shock to existing home owners who have equity and don’t actually need mortgage insurance, but are looking to trade up to a larger house, refinance their existing home, switch to another lender, or apply for a home equity line of credit.
The fact is that since 2017, the Office of the Superintendent of Financial Institutions has required that all prospective home buyers looking for financing must complete a stress test, which calculates whether they can afford the mortgage loan payments based on their income, property tax, and any other debts they may have, like credit cards, car payments, consumer or student loans.
Previously lenders were stress tested using a mortgage qualifying rate of 4.79%, or the contract rate plus two percentage points, whichever was greater. Most buyers were able to qualify at the 4.79% rate. Under the recently revised rules, however, for both insured mortgages (down payment less than 20%) and uninsured mortgages (down payment over 20%), the stress test uses the higher of either the Bank of Canada benchmark 5.25% or the interest rate you negotiate with your lender plus two percentage pointsYou must be able to meet your mortgage payments if your rate increases to this new qualifying rate.
For example, if your mortgage interest rate is 1.99%, you must show you can qualify at a 3.99% rate. If your rate is currently 4.5%, you must be able to qualify at the Bank of Canada’s 5.25%. This means that if you are contemplating a $600,000 mortgage, even if you can afford the $2,537.81 monthly payment at the 1.99% rate (based on a 5-year fixed rate mortgage, with 25-year amortization), you’ll have to show that you can afford the $3,152.87 monthly payment at the 3.99% rate before you qualify for the loan.
In my discussion of the stress test, I mentioned “insured” and “uninsured” mortgages. This may also come as a surprise to first time buyers looking to purchase home with a small down payment. The fact is that if you are putting a down payment of less than 20% on your home purchase and taking a mortgage loan for the rest, the rules say you need mortgage loan insurance to protects the lender in case you default.
With the Canada Mortgage and Housing Corp. (CMHC) mortgage loan insurance, you may qualify for a mortgage of up to 95% of the purchase price of your home, provided it is less than $1 million. There are minimum down payment thresholds, however, depending on the price you pay for the home:
- $500,000 or less: Minimum down payment of 5% ($25,000)
- Over $500,000: Minimum 5% down on the first $500,000 ($25,000) and 10% on the remainder.
Your minimum down payment must come from your own resources (which could include a gift from a relative).
According to the CMHC, your total monthly housing costs, including principal, interest, property taxes, heating (PITH) should be no more than 32% of your gross household income. This is called your Gross Debt Service (GDS) ratio. If applicable, annual site lease in the case of leasehold tenure and 50% of condominium fees must also be added in.
In addition, your Total Debt Service ratio (TDS) should be no more than 40% of your gross household income. This is calculated as your PITH plus payments on all other debt divided by your gross annual household income.
Don’t forget about closing costs, which could add up to to 1.5% to 4% of the purchase price. These include such one-time items legal fees, GST and PST as applicable, land transfer tax if applicable, adjustments, and other fees that are necessary for you to close the house purchase.
Determining whether you qualify for a mortgage and then negotiating one on the best terms possible can be a tricky business. Get the advice of a qualified financial professional to ensure you don’t get in over your head.