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On behalf of JCA Law Office on Friday, July 20, 2018.

Until this year, homebuyers needed to buy mortgage insurance if they could only afford to pay between five and 20 percent of the price of the property in their down payment. Only these homebuyers had to pass the stress test before they would get a mortgage. Now the rules have changed.

After January 1, almost all homebuyers began taking stress tests to see if they could afford the mortgage payments to buy a condo or house. Failing the test means that many homebuyers must buy a smaller home than they wanted – or not get a mortgage from banks and credit unions.

The Bank of Canada estimates 10 percent of borrowers who can make a down payment of 20 percent or more of the property’s cost will still not be able to secure a mortgage.

How the Stress Test Works

The stress test increases the interest rate that a homebuyer would be charged by two percentage points above either of the below, whichever is greater:

the Bank of Canada’s five-year benchmark lending interest rate; or
the current interest rate the lender charges for mortgages,
If a bank charges a five percent interest rate for mortgages, the bank calculates whether or not the homebuyer could pay the mortgage payments if the interest rate was seven percent, not five percent.

For example: assume that

the homebuyer wants a 25-year amortization period for their mortgage and
can make a down payment of 20 percent of the purchase price.
Then, possible mortgage payments are calculated at current interest rates:

under the old rules, the homebuyer must make $500 in monthly mortgage payments for every $100,000 of mortgage debt; but
under the new rules, the homebuyer must to able to pay $600 a month for every $100,000 in mortgage debt – even if the actual monthly payment is only $500 a month per $100,000 of mortgage debt.
How the Stress Test Result Can Change A Lender’s Decision About A Mortgage

Lenders decide how much a homebuyer can afford based on two ratios: the Gross Debt Service (GDS) ratio and the Total Debt Service (TDS) ratio.

The Gross Debt Service ratio is the percentage of pre-tax income that

a home buyer needs to pay their mortgage payment plus the monthly cost of property taxes, divided by their gross monthly (pre-tax) pay; or
a condominium buyer needs to pay the mortgage payment plus half of their monthly condo fees and the heating costs, divided by their gross monthly (pre-tax) pay.
If this ratio is less than 32 percent, most lenders will consider granting a mortgage. Lenders then consider the Total Debt Service ratio.

The Total Debt Service ratio is the percentage of pre-tax income that is needed to pay a homebuyer’s monthly debts, including credit cards, lines of credit, car loans and any other debts. The monthly mortgage payment is then added to the payments for these debts. The lender will probably grant a mortgage if the TDS is 42 percent or less of a homebuyers gross monthly income.

The stress test increases the mortgage payment amount when the GDS and the TDS are calculated. A home buyer would not get a mortgage if the amount added to the mortgage payment pushes the ratios above the GDS’ 32 percent and the TDS’ 42 percent limits.

What To Do When A Homebuyer Fails The Test

A homebuyer has two choices:

Buy a cheaper home. This lowers the amount of the mortgage payments so that the homebuyer passes the stress test.
Borrow from an alternative lender. These are smaller financial companies that the government does not insure. These lenders charge a much higher interest rate (eight to 11 percent) than banks do, as their risk is higher if the homebuyer defaults.
If interest rates climb further, still more people will see their chances of owning one’s own home fade because of the stress test.