The Office of the Superintendent of Financial Institutions (OSFI) announced as part of an annual review Thursday that the minimum qualifying rate for uninsured mortgages — commonly known to homebuyers and refinancers as the stress test — will not change from its current levels.
The regulator, which is in charge of setting the stress test for uninsured mortgages in Canada, says it’s “prudent” to maintain the standard even as interest rates increases from the Bank of Canada press borrowers to qualify at higher rates.
While some experts who spoke to Global News on Thursday said there is a “valid argument” for lowering the stress test to ease housing affordability concerns, most agreed that the standard has so far proved effective in protecting Canadian homeowners and lenders from the shock of higher interest rates.
What is the mortgage stress test?
Today, those applying for a mortgage have to prove they can handle payments that are higher than their actual contract rate given by their lender. That rate remains 5.25 per cent or the mortgage contract rate plus two percentage points, whichever is higher.
For much of the COVID-19 pandemic, when the Bank of Canada’s key interest rate was at historic lows, many Canadian borrowers were qualifying at the 5.25 per cent rate.
That’s changed with the central bank’s rapid hikes to its benchmark rate through 2022.
After Canada’s biggest banks raised their prime lending rates to 6.45 per cent in response to the Bank of Canada’s 50-basis-point rate increase last week, the stress test for some Canadian mortgage seekers is hitting above eight per cent.
Some provincially regulated lenders are not required to subject borrowers to OSFI’s stress test. OSFI’s stress test also only applies to uninsured mortgages, though the federal Department of Finance has matched the regulator’s qualifying standard on insured products.
The department confirmed in a statement Thursday that Ottawa’s test for insured mortgages will also remain unchanged.
Why do we have a mortgage stress test?
The goal of the stress test, according to OSFI, is to protect Canadian borrowers by ensuring they can continue to make loan payments amid sudden rises in interest rates or economic downturns.
OSFI said in a brief statement Thursday that while today’s mortgage applicants are already qualifying in a higher rate environment, the stress test remains a “sound” practice for lenders.
“In an environment characterized by rising mortgage interest rates, sustained high inflation and potential risks to borrower income, it is prudent that lenders continue to test borrowers for adverse conditions,” the statement read.
Speaking to reporters on her way out of the Liberal cabinet meeting Thursday, Finance Minister Chrystia Freeland said that Canada’s “well-regulated mortgage system” is among the “fundamental strengths” of its financial sector.
She cited protections in the mortgage space as one of the reasons Canadian banks were not as hard hit in the 2008 financial crisis.
“In the situation that we’re in today, it makes sense for Canada to continue with our tradition of being careful, being thoughtful, being prudent. That’s the approach that OSFI has taken and that’s the approach that the Ministry of Finance has taken,” Freeland said.
Is the stress test effective?
Economists and real estate experts who spoke to Global News on Thursday largely agreed the stress test seems to have done its job through 2022, as rapidly rising rates could have overwhelmed buyers and spurred a rise in mortgage defaults.
Tolga Yalkin, assistant superintendent at OSFI, told reporters in a press conference Thursday that the regulator credits the stress test with keeping mortgage delinquency levels “at or near historic lows.”
“This margin of safety made it easier for Canadian homeowners to pay their mortgages and stay in their homes while rates start rising,” he said.
Stephen Brown, senior Canada economist at Capital Economics, tells Global News that while the stress test is “definitely not popular” among homebuyers, the relative stability of the housing market in 2022 is proof positive for the stress test’s effectiveness.
He points to Canadian Real Estate Association (CREA) statistics also released Thursday that showed a decrease in new home listings in November.
If Canadians were unable to keep up with their mortgages as costs rise, we’d be seeing a wave of properties flooding the market, he argues — something Canada did see in the 1980s when rates rose rapidly without a buffer in place. OSFI’s stress test was introduced in January 2018.
“New listings rose very sharply (in the ’80s) because people were being forced to sell their homes en masse almost, whereas we’re seeing the opposite happened this time. People were able to sit on the sidelines, even though (these higher interest rates are) biting, it’s not forcing them to sell these homes because they can’t afford them,” he says.
What impact would OSFI lowering the stress test have had?
Shifting the stress test would have an immediate impact on housing demand and buying power, according to experts who spoke to Global News.
Victor Tran, mortgage and real estate expert with Rates.ca, says that for every 25 basis points higher the stress test were to rise, the average buyer would lose $10,000 to 15,000 in buying power on the final purchase price of a home.
Keeping the stress test as it is means Canadians will have to qualify for mortgages at higher rates given the Bank of Canada’s decision last week, which will continue to erode affordability, Tran says.
If OSFI were to have eased the stress test, it would have expanded Canadians’ borrowing power.
John Pasalis, president of Realosophy Realty in Toronto, says that there’s a case to be made for dropping the stress test now that rates have already risen. It’s unlikely that interest rates will rise another two percentage points further, given messaging from the Bank of Canada about a possible pause in hikes on the horizon, he notes.
“Can they relax it a little bit now as we start going into this more stabilized or … downward trend in interest rates potentially? I think it’s a valid argument,” Pasalis says. “But again, I think policymakers want to be taking a very conservative position right now.”
Brown says that now might not be the time to lower the guardrails on the Canadian housing market.
While it’s true rising rates have not yet led to extensive mortgage defaults in Canada this year, higher interest rates can take a year or longer to work their way through the system. Mortgage holders with fixed rates or static payments won’t feel the pain of higher rates until they renew, Brown notes, and the market could feel the impact of surging borrowing costs on a delay.
At the same time, fears of a looming recession could lead to job losses in Canada in the months to come, with Capital Economics projecting the unemployment rate could rise to 6.5 per cent next year from the rate of 5.2 per cent seen in November.
The stress test is designed to insulate the mortgage industry from not only higher rates, but also from unexpected hits to income, Brown notes.
“Many of those people (who could lose jobs) will be homeowners and might get themselves into difficulty. But because of the very stress test, maybe they proved they got some savings. They can put those two to work. It gives them a bit of a buffer,” he says.
And just because interest rates have risen significantly in 2022, doesn’t mean they couldn’t rise further in 2023 if there are further shocks to the global economy like the war in Ukraine this past year, Brown adds.
What other changes could be made to the stress test?
OSFI also said it will launch a review of the stress test and other mortgage underwriting standards in January. The regulator said it expects to leave the stress test in place after its review, “although the economic environment could result in a more immediate change.”
At the end of the summer, the Toronto Regional Real Estate Board (TRREB) had called for OSFI to review the stress test to give consumers more flexibility to switch their mortgages to a different lender. Currently, when a mortgage holder is refinancing or looking to switch lenders, they have to requalify for the mortgage under the stress test’s parameters.
Pasalis agrees mortgage renewers could benefit from added flexibility in the current interest rate landscape, to renegotiate the amortization on their mortgage to a more lenient payment schedule or secure a cheaper rate with another provider.
Such moves would not initiate a new mortgage — introduce new risk into the system — but rather help homeowners mitigate the impact of rising rates and possibly avoid defaulting, he says.
“It’s that space where I think it’d be more prudent to have a few changes to make it a little bit easier for existing homeowners,” Pasalis says.
OSFI has committed to reviewing the stress test annually.
— with files from Global News’ Kyle Benning
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