As of Jan. 1, Canadians getting, renewing or refinancing a mortgage might have to undergo a stress test, proving that they would be financially OK even if interest rates were to rise substantially above their actual mortgage rate.
That’s because new federal guidelines came into effect at the beginning of the year. They require all federally regulated financial institutions to vet borrowers’ applications using a minimum qualifying rate equal to the greater of the Bank of Canada’s five-year benchmark rate (currently 5.14 per cent) or their contractual rate, plus two percentage points.
The regulations affect all six of Canada’s big banks. Some provincially regulated lenders, like credit unions, are also voluntarily complying with the guidelines.
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Broadly speaking, the rules mean you may not be able to borrow as much as you would have been able to before the start of the year. If you’re house hunting, you may have to settle for a less-expensive home. If you’re renewing your mortgage, you may be forced to stay with your current lender. This allows you to side-step the stress test but it also means you can’t shop around for a better mortgage. And if you’re hoping to refinance, you may not be able to boost your loan by as much as you’d like – if at all.
There might not be much you can do to change the math in your favour, but it might help to have a rough idea of what you’re up against before you walk into your bank, sit down with a mortgage broker or meet up with a real estate agent.
There’s a simple rule of thumb Canadians can use to estimate how the stress test will affect them, according to Allan Tran, a Hamilton, Ont.-based business development manager at Meridian, a credit union.
Canadians who can afford a down payment of 20 per cent or more are currently facing about $500 in monthly mortgage payments for every $100,000 of mortgage debt, assuming a 25-year amortization period, Tran told Global News. The new rules mean they have to qualify as if their monthly payments were about $600 for every $100,000 worth of mortgage.
If you want to stress test your finances, ask yourself what would happen if you had to pay $600 a month for every $100,000 on your mortgage balance, Tran said. That’s a useful exercise regardless of whether or not you actually face the test, given that interest rates are rising, he added.
The way lenders decide what you can afford is based on a couple of main metrics, the gross debt service ratio (GDS) and the total debt service ratio (TDS), Tran said.
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Gross debt service ratio
The GDS is the percentage of your pre-tax income needed to pay your housing costs. In addition to the stress-tested (i.e. higher) monthly mortgage payment, your bank will look at the monthly cost of your property taxes or half of your condo fees and your heating costs. They add all that up and divide by the amount of your gross monthly pay. If the ensuing ratio is around 30-32 per cent, most lenders will give you the green light on your mortgage application, Tran said.
Condo fees often include things like cable, insurance and electrical costs, so that’s why financial institutions only include half of them in the GDS, Tran explained. That said, condo fees are “where many people get lost,” meaning that they push borrowers over the 30-32 per cent threshold.
Tran cautioned against lowballing condo fee estimates when doing your back-of-the-envelope math. Also, keep in mind that these fees tend to go up with inflation, rising by 1.5-2 per cent per year.
On the flip side, Tran often sees clients underestimating their own income. People who get paid every two weeks tend to calculate their monthly pay as twice their bi-weekly pay, but that’s not quite right.
Say you make $2,000 in pre-tax income every two weeks. First, calculate your annual income by multiplying that by 26 (there are 52 weeks in a year). Then divide that by 12. What you get isn’t $4,000 but $4,333. That extra $300 a month might just be enough to put you over the edge in a GDS calculation, Tran noted.
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Total debt service ratio
Lenders will also want to know how much of your income will go to covering your debts. That’s the TDS. Your debt payments include credit cards, lines of credit, car loans and any other secured or unsecured debts, Tran said. Add all that up and it should take up no more than 42 per cent of your pre-tax monthly pay.
Now, just because you passed the GDS test doesn’t mean you’ll meet the TDS requirement. Car loans, in particular, are a fixed debt cost that can have a big impact on that ratio and disqualify borrowers.
“That’s the ‘oh my God’ moment for a lot of people,” he said.
On the other hand, if you have, say, $1,000 a month worth of credit card charges every month but always pay off your balance in full, the amount of credit card debt that will appear in your TDS equation is zero. Lenders will rely on “whatever the credit bureau is going to show,” Tran said. It’s up to you to make sure you’d be able to keep up those credit card payments after getting a new mortgage.
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When you fail the test
Failing the test means you’ll have to adjust your numbers somehow. You might have to be content with a smaller mortgage or have to pay off your car before applying again.