In late 2017, OSFI, the agency that supervises and regulates Canada’s banks, unveiled a new mortgage stress test, designed to protect Canadian borrowers from increasing debt burdens, and the prospect of rising interest rates. It also served to cool off a couple of Canada’s most expensive housing markets at the time. This test, which is really a set of rules, targets anyone who applies for a mortgage from a Canadian bank, regardless of their down payment amount.
In this article, I’ll cover everything you need to know about the mortgage stress test, including how it’s calculated, and what you as a potential homebuyer can do to prepare for tighter lending rules. But first, let’s take a look at the regulatory agency behind the mortgage stress test.
What Is OSFI?
OSFI is short for The Office of the Superintendent of Financial Institutions. The independent agency of the Government of Canada is tasked with regulating the banking and insurance industries in Canada, as well as trust companies, loan companies, and pension plans. This includes supervising institutions and pension plans to ensure they are operating in accordance with regulatory laws, and advising them when corrective action is required. Some financial institutions, such as credit unions, don’t fall under OSFI supervision, leaving them independent from rules like the mortgage stress test.
How Does the New Mortgage Stress Test Work?
When you apply for a mortgage, the bank uses a qualifying interest rate to determine how much of a mortgage you can afford. Under mortgage stress test rules, this is determined as the greater of the Bank of Canada’s posted five-year-rate, or the rate your bank is offering you, plus an additional 2%.
As of this writing, the Bank of Canada rate is 5.19%. If your bank was offering you 2.99% on a 5-year mortgage, an additional 2% would bring it to 4.99%, thus, your qualifying rate would be the Bank of Canada’s 5.19%. On a $300,000 mortgage, the payment you would need to qualify for would be approximately $1780/month. Your actual mortgage payment, at 2.99%, would be $1420.00. In this case, the mortgage stress test impacts affordability by more than $350/month.
How Does the Bank Measure Affordability?
Banks determine mortgage affordability by using two standardized ratios: Gross Debt Servicing (GDS) and Total Debt Servicing (TDS). GDS measures your total monthly housing costs (mortgage + utilities + property taxes) as a percentage of your monthly gross income, with 32% being the maximum as a general rule. TDS takes into account your housing costs, as well as any other monthly payments you make towards credit card balances, loans, or lines of credit. While there can be small exceptions made, 40% is considered the maximum TDS.
In other words, regardless of your annual income, as soon as your monthly obligations (TDS) exceed 40%, you’re going to begin to feel the pinch. That’s the way the bank looks at it. Of course, people’s lifestyles and spending patterns vary, but banks have to settle on a standardized measurement. Using a $300,000 mortgage, the following scenario illustrates how GDS and TDS are calculated:
Calculating GDS and TDS
- Borrower’s pre-tax monthly income: $8000
- Mortgage amount: $300,000
- Qualifying rate & mortgage payment (P&I): 5.19% / $1780
- Monthly utilities: $150
- Monthly property taxes: $200
- Car Loan: $360/mth
- Line of credit minimum payment: $125/mth
Maximum GDS/TDS for this borrower:
- $8000 X 32% = $2,560
- $8000 X 40% = $3,200
- $1780 + $150 + $200 = $2,130.00 (total housing costs)
- $2130/$8000 = 27% GDS
- $2130 + $360 + $125 = $2615 (total monthly obligations)
- $2615/$8000 = 33% TDS
In this case, you can see that the borrower meets both the GDS and TDS guidelines, at 27%/33% respectively. Had the borrower’s total monthly obligations exceeded $3200 (40% TDS), a $300,000 mortgage would have been considered unaffordable. I should note that the mortgage stress test still impacted this borrower’s affordability, due to the qualifying rate used. While they can manage a $300,000 mortgage, the ceiling on what they might be able to afford is still going to be reduced by as much as 20%.
The Future of the Mortgage Stress Test
Many would agree that the mortgage stress test has accomplished what it was intended to do, by sheltering more Canadian borrowers from the fallout of rising interest rates, while easing prices in overheated markets like Toronto and Vancouver. On the other hand, there are critics who say it’s gone too far and placed the dream of homeownership out of reach for too many young Canadians. It even showed up as an election issue recently, with one political party committing in their platform to loosen mortgage stress test rules.
What Are My Options With the Mortgage Stress Test?
When the stress test was first introduced, it only applied to CMHC/Genworth insured, high ratio mortgages. In other words, mortgages with a down payment of less than 20%. It now applies to all bank mortgages, regardless of down payment size. While future changes are always possible, it’s best to factor in the stress test when you budget for a mortgage. Depending on your situation, this might require taking one or more of the following into consideration:
- Buying in a more affordable area
- Reducing your purchase price
- Setting aside a larger down payment
- Finding a way to increase your income
- Paying off other debts in advance
If you’re struggling with affordability due to the stress test, you could shop around for an institution that isn’t subject to OSFI rules. This would include credit unions, as well as a number of other FI’s not encumbered by a stress test mortgage. A mortgage broker could likely help in this regard.
The Mortgage Stress Test – Other Considerations
The mortgage stress test is one thing you need to consider when shopping for a mortgage, but there are others. For example, prepayment options (how much extra you can pay without being penalized) vary between institutions and mortgage types. You should also think about how long you plan to stay in the home you’re buying, as that may factor into your decision. My overall advice is to be conservative. While your bank is always willing to lend the maximum amount you are approved for, only you truly know what you can afford.