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A History of the Mortgage Stress Test

Canada rolled out a mortgage stress test that first went into effect in 2018. It had two main purposes. One was to lower the risk that mortgage lenders were taking by lending to those who might not be able to afford their homes if interest rates went up. This reduced the risk of Canadian mortgage lenders going out of business if Canada’s housing bubble burst the way the U.S. housing market did in 2007. The other was to cool Canada’s then over-heated mortgage market, hopefully preventing an over-inflated real estate bubble.

What Is the Mortgage Stress Test?

The mortgage stress test uses a higher interest rate than the current one being offered by lenders to determine if someone is able to afford their mortgage. This ensures that they can make the payments if their variable rate mortgage spikes several percentage points or if their mortgage renewal in a few years is at a higher interest rate.

This is similar to the stress tests done as part of retirement planning. In those scenarios, financial advisors determine if you can still pay the bills if investments only make 4% instead of the more optimistic 5%. If the answer is no, you either need to save more for retirement or plan on reducing lifestyle in retirement. The stress test ensures that you can weather a market downturn and won’t run out of money. Banks were forced to do stress tests on potential borrowers for the same reason.

The mortgage stress test applies to all mortgages issued through the Big Six banks. These rules typically do not apply to private mortgage lenders. Nor do they matter if you pay cash for a home.

The First Generation of the Mortgage Stress Test

The mortgage stress test rolled out in 2017 applied to all uninsured and high-ratio mortgages. For example, you had to undergo the mortgage stress test if you were putting less than 20% down on the home. This stress test level used an interest rate either:

  • 2 full percentage points above the actual mortgage rate
  • The average of the five year posted rate as calculated by the BoC

And they used whatever value was higher in the stress test. That means that someone might be subject to the higher BoC value even as interest rates were falling.

This was in addition to other rules that went into effect to cool the housing market such as eliminating the 30-year mortgage and no longer offering insurance on homes valued at over a million dollars. This led to many people going to alternative lenders to get a private loan to cover the difference between their down payment and the 20% threshold required to eliminate mortgage insurance. At the same time, government officials at a provincial and federal level started cracking down on private mortgage lenders. For example, they could be penalized for accepting borrowers with a debt to income ratio of over 44%, no matter the size of their down payment.

The main goal of these regulatory changes was to curtail the issuing of mortgages that weren’t likely to repay them if the economy went into a recession.

Weren’t There Other Steps Taken to Cool Canada’s Hot Housing Market?

The federal mortgage stress test was separate from various provincial-level efforts to cool local housing markets. For example, British Columbia applied a 15 percent tax on foreign house buyers around the same time. This was mostly aimed at Chinese condo buyers (often buying through corporations) snapping up homes they didn’t live in. The foreign buyer tax was later raised to 20%.  This is understandable, given that non-resident homeownership approached five percent in BC and four percent in Ontario in 2017. And local residents were priced out of the housing market.

An additional tax was slapped on speculative buyers who didn’t pay income tax in BC. British Columbia also applied a vacancy tax of 1 percent on homes unoccupied more than six months out of the year. BC even passed a higher property tax on properties valued over three million dollars.

Rules like this were unnecessary in cooler real estate markets like Alberta’s. They never saw the average home value pass a million dollars. However, even Calgary private mortgage lenders were subject to new restrictions. For example, they were no longer allowed to offer prizes to those who signed up for a higher interest rate and no longer allowed to use an assignment of wages agreement.  However, the mortgage stress test had the greatest impact across the country, since it affected nearly all home buyers and even a few other types of mortgage customers.

The 2018 Mortgage Stress Test

At the end of October 2017, the mortgage stress test was made nearly universal. For example, it was applied to Canadians who put down 25% on a property and thus didn’t need mortgage insurance. It even applied to current homeowners who wanted to switch mortgage lenders. This forced many people to renew their mortgages with their current lenders, regardless of the interest rate. One study suggested this happened to five to ten percent of mortgage renewers, though they could clearly afford their home and could save money by switching mortgage lenders.

Tighter loan to value rules also started to affect home equity loans and cash-out refinances, though they bought the home when a 5% percent down was allowed. That meant your home equity loan plus your mortgage could no longer exceed 80% of the mortgage.

The 2019 Changes to the Mortgage Stress Test

In 2019, the mortgage stress test was relaxed a little. That is aside from the fact interest rates themselves fell. For example, the qualifying interest fell to 5.34%, matching the Bank of Canada average 5-year posted rate of 5.34% in March of that year.

An interesting loophole in the mortgage stress test rules was choosing a variable rate mortgage. That made it easier to pass the stress test, given the lower variable interest rate. Another possible work-around was choosing a shorter loan term.  Because the mortgage stress test applied to federally insured lenders, this caused Quebec financial institutions to see a temporary boom in mortgage lending. Credit unions in other provinces were exempt from the stress test for a while, too.

The 2020 Mortgage Stress Test

Critics of the mortgage stress test said that the Big Six banks were keeping their posted rates high to increase their profit margins through higher pre-payment penalties, though this subjected borrowers to unreasonably high interest rates in the stress test. That limited the number of qualified home buyers and led to a chilling of the Canadian housing market.

The April, 2020 mortgage stress test rules set the qualifying interest rate used in the stress test at the average 5 year fixed rate for mortgages set that week. This makes the mortgage stress test more responsive to interest rate changes and eliminates the higher standard set by banks setting their own, artificially high posted rates. This will allow many more potential home buyers to qualify for a mortgage, and everyone will benefit from lower interest rates. A side benefit of the change is that it came in time for the spring housing rush. This will lead to a much busier and healthier 2020 housing market.