Getting a Mortgage now – What is a “stress test”?

The Bank of Canada’s recent decision to raise interest rates generated a lot of media attention, because while the increase itself was only one quarter of a percentage point, it was the first move made by the Bank of Canada to increase rates in the past seven years    Speculation was whether this or future increases in interest rates would act as a barrier to those seeking to get into the housing market.  The mortgage financing “stress test” — is likely one that is unfamiliar to most Canadians, even those who are affected by it.

When anyone seeks to borrow money, a key factor in determining their ability to obtain a loan is, their ability to repay the loan/That same consideration applies when an individual or a couple apply for approval or pre-approval of a mortgage.

In determining whether a borrower will be able to repay the mortgage loan as required, mortgage lenders rely on two debt-to-income ratios, known as Gross Debt Service (GDS) and Total Debt Service (TDS). The two are similar, but not the same.

The GDS ratio measures how much of the would-be borrower’s income will be needed to meet his or her housing costs. For any borrower, GDS represents the total of mortgage payments, property taxes, heating costs, and — where applicable — one-half of condo fees. Optimally, that total figure will represent less than 35% of the would-be borrower’s income.

Of course, most Canadians carry one or more kinds of consumer debt besides their mortgages, and so it’s necessary to determine their cost of servicing that total debt as a percentage of income. That figure is their TDS, which is the total of housing expenses (as calculated for purposes of GDS) plus any other debt repayment, including car loans, credit cards, lines of credit, and student loans. Optimally, the total amount of housing costs plus other repayment will be less than 42% of the would-be borrower’s income.

Where a would-be borrower is particularly credit-worthy (e.g., he or she has a reliable source of income and a good credit history), lenders will provide mortgage financing even where the optimal debt ratios indicated above are exceeded. However, the maximum GDS and TDS ratios allowed are, respectively, 39% and 44%.

While the GDS and TDS ratios do provide a reasonable measure of the ability of a prospective borrower to repay funds advanced to him or her, the weakness of those ratios are that they provide only a “snapshot” of the individual’s housing costs and debt repayment costs at a point in time and, more significantly, at current interest rates. As everyone knows, interest rates in Canada are, and have been for several years, at or near records lows and that many Canadians have taken advantage of those low rates. Specifically, as of the first quarter of 2017, the average debt load of Canadian households (including mortgage debt) stood at 167.3% of disposable income.

The combination of those two factors means that Canadian households are, on average, carrying much higher levels of debt (as a percentage of disposable income) and that the cost of carrying such debt is at or near record lows. When, as has recently proven the case, those interest rates begin to rise, such increase has the potential to put Canadian households on financial thin ice. And that possibility is what gave rise to the introduction by the federal government of the “stress test” which might equally well be called the “what-if?” test.

Basically, the stress test requires that lenders assess a would-be mortgage borrower’s ability to manage their debt, not only at current interest rates, but at the higher rates which those borrowers will certainly face sometime during the life of their mortgage. Carrying out a stress test is, in fact, something which financial planners advise clients to do as part of financial planning whenever taking on debt is contemplated. It’s simply prudent (especially where debt is longer term in nature and consequently higher payments resulting from an increase in interest rates is inevitable) to consider, not just whether the debt is manageable at current interest rates, but whether it will remain manageable where those interest rates rise by 1, 2, or 3% — or more. The “stress test” simply creates a requirement out of something that was always a good idea.

It’s true that the application of the “stress test” as interest rates rise will cause more borrowers to be unable to qualify for a mortgage, or will require them to reduce their expectations in terms of the amount of mortgage financing for which they can qualify. But, it’s also the case that would-be borrowers who cannot “pass” a stress test are the very borrowers who would be put most at risk by an increase in interest rates. Where interest rates will be a year or two from now is something that no one — including the Bank of Canada — knows. It is undoubtedly disappointing for would-be borrowers to have to reduce their expectations with respect to the amount of mortgage financing (and therefore the “amount” of house) they can obtain. That scenario is, however, infinitely preferable to one in which they discover down the road that they can no longer afford to carry their mortgage at the higher interest rates then in effect, and are at risk of defaulting on that mortgage and potentially losing their home.