Rising interest rates and the mortgage stress test - Akler Browning LLP

Over the past several years, would-be buyers in the Canadian residential real estate market have been faced with two realities. First, the cost of homes continued to increase significantly in virtually every market across Canada. At the same time, however, the cost of borrowing to finance a home purchase had almost never been lower.

At least one of those realities came to an end in April 2022, when the Bank of Canada increased its benchmark interest rate by a full one-half percentage point – the largest such rate hike in more than 20 years. At the same time, the Bank signaled in its press release announcing the rate hike decision that more such increases were likely on the horizon, as the Bank seeks to bring the current inflation rate of 6.8% closer to its target rate of 2%.

While a one-half percent rate increase doesn’t necessarily sound like a lot, each increase in interest rates results in a change in what’s called the “mortgage stress test” – and those changes drive down the amount of mortgage financing for which most first-time home buyers can qualify, and consequently the maximum price they can consider paying for a home.

To understand that mortgage stress test, some background is required. Mortgage lending rules have always been more conservative in Canada than they are in the United States. However, it was at one time possible to purchase a home in Canada without providing any down payment, and to finance the repayment of the full purchase price over the next 40 years – longer than the working life of many Canadians.

In 2008 the US mortgage market was collapsing under the weight of hundreds of thousands of mortgage defaults. While that scenario fortunately never played out in Canada, the Canadian government determined that changes were needed to existing Canadian mortgage lending rules, in large part to avoid such a possibility. Those rules were tightened in many steps over the subsequent 10 years, leading eventually to the imposition of the mortgage stress test in 2016 and a furthering tightening of that test in 2017 and 2021. Essentially, the mortgage stress test imposes additional income and creditworthiness requirements on would-be borrowers with the goal of ensuring that they will be able to manage (and repay) their mortgage debt at both current interest rates and at potentially higher rates in the future.

Lenders have always, of course, assessed the creditworthiness of individuals who apply for mortgage financing – or any kind of loan. When an applicant seeks mortgage financing, lenders use two tests to determine the applicant’s ability to manage the borrowing sought. The first, the Gross Debt Service (GDS), is a measure of housing costs, and includes mortgage payments, property taxes, heating, and, where applicable, one-half of condominium fees. Lenders want to see that no more than 35% to 39% of a household’s gross income is needed to meet the GDS. The second measurement, the Total Debt Service or TDS, includes housing costs plus all other debt obligations (student loans, car payments, etc.). When it comes to TDS, lenders want to see that payment of total debt obligations utilizes no more than 42% to 44% of the borrower’s gross household income.

In addition to these tests imposed by a lender, the mortgage stress test requires would-be borrowers to satisfy additional, more stringent, criteria. Specifically, such borrowers must meet the GDS and TDS ratios based on both the actual mortgage interest rate which the lender is providing and a higher notional rate. In effect, a borrower must show that he or she has sufficient total income and disposable income to continue to be able to meet mortgage payment obligations in the event that mortgage interest rates increase – as they just have.

Anyone applying for mortgage financing (including both first-time buyers and current homeowners renewing their mortgages or moving to a new lender) must meet the GDS and TDS ratios using the actual rate negotiated with the lender plus 2%, or the notional rate set by the federal government, whichever is higher.

As of June 2021, the notional rate imposed under the mortgage stress test was increased to 5.25% for all mortgages, regardless of the size of down payment. At that time, the 5.25% rate was, usually, the higher of two possible rates which could be imposed under the mortgage stress test, meaning that prospective borrowers had to show that they could meet their mortgage payment obligations based on a notional rate of 5.25%. However, following the recent interest rate increases announced by the Bank of Canada, major Canadian lenders have increased their mortgage lending rates. As of mid-May, the lowest rate offered by a major Canadian bank for a five-year fixed rate mortgage was 4.36%. As a result, under the terms of the mortgage stress test, prospective buyers will have to show that they satisfy lending criteria based on a notional rate of 6.36%, as that rate is higher than the notional 5.25% rate set by the federal government.

The recent changes create a kind of double jeopardy for prospective borrowers. As the result of the higher notional rate imposed under the mortgage stress test, such borrowers will qualify for less in the way of mortgage financing, narrowing the range of properties on which they can make an offer to purchase. And, at the same time, such prospective homeowners are faced with the certainty that, should they be successful in making an offer to purchase and obtaining mortgage financing, the cost of servicing that mortgage will be higher than it would have been just a few months ago.

While both these changes are undoubtedly discouraging to Canadians trying to get a foothold in the residential real estate market, they are the new reality for would-be home buyers. And, while predicting the future of interest rates is a fool’s game, current economic realities (along with the signals issued by the Bank of Canada) would seem to make it very unlikely that interest rates will be declining any time in the near future. Those trying to adjust to the new interest rate reality (which includes but certainly isn’t limited to first-time home buyers or those renewing their mortgages) can find some guidance on the website for the Financial Consumer Agency of Canada at https://itools-ioutils.fcac-acfc.gc.ca/MQ-HQ/MortgageQualifier.aspx?lang=eng&lang=eng and https://www.canada.ca/en/financial-consumer-agency/services/interest-rates-rise.html.