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How Does the Rising Stress Test Impact Mortgage Affordability?

Jordan Lavin

Interest rates are on the rise, and the mortgage stress test is shrinking the amount of mortgage you can afford. What does a rising stress test mean for you and your homeownership dreams? Let’s take a look at the mortgage stress test and how it affects mortgage affordability.

What is the mortgage stress test and how is it used?

When you get a mortgage, the lender wants to be confident you can make your payments. One of the calculations they use to do this is called your debt service ratio, which compares your housing costs and other debt payments to your income. Mortgage lenders usually want your gross debt service ratio (the cost of housing including your mortgage, property taxes, condo fees, and heat) to be no more than 39% and your total debt service ratio (the cost of housing plus all your other payments) to be no more than 44%.

You can’t lock in a mortgage rate for more than 5 years in Canada, so lenders also want to be assured you’ll be able to make your payments in the future should rates go up. To “stress test” your ability to pay a higher mortgage rate on renewal, lenders calculate your debt service ratios using a mortgage rate that’s much higher than the rate you’ll actually pay. You can simulate different stress test scenarios to see what your monthly mortgage payment would be using Ratehub.ca’s mortgage payment calculator.

 

What is the relationship between mortgage rates and the stress test?

The qualifying rate you’ll be stress tested against is the higher of 5.25% or your contracted mortgage rate plus 2%. Until recently, discounted mortgage rates were low enough that almost everyone was stress tested using a qualifying rate of 5.25%, but thanks to a sharp rise in mortgage rates more Canadians are being subjected to an even tougher stress test. If you were to get a 5-year fixed mortgage with today’s best rate of 3.59%, your lender would calculate your debt service ratios using a qualifying rate of 5.59%.

 

What do higher mortgage rates mean for your ability to afford a mortgage?

When you pay a higher mortgage rate, your monthly payment has to increase to cover the additional cost of borrowing. As a result, the maximum mortgage amount you’ll qualify for is reduced as rates rise.

Let’s say you have a household income of $100,000 per year. To stay within the maximum 39% gross debt service ratio, your total housing expense can be no more than $3,250 per month. Assuming your additional housing costs are $1,000 per month, that leaves you with $2,250 per month for your mortgage payment.

According to Ratehub.ca’s mortgage affordability calculator, if you were qualified at today’s best mortgage rate of 3.59%, you could afford a purchase price of $481,000 with a 10% down payment. However, because your minimum qualifying rate would be 5.59%, you would actually qualify for a purchase price of just $393,800.

If mortgage rates were to rise by another 1%, your maximum affordability would fall to just $359,100 – a drop of $34,700.

Qualifying rate

Maximum purchase price

3.59%

$481,000

5.59%

$393,800

6.59%

$359,100

 

Is the stress test itself getting tougher?

While rising interest rates are eroding mortgage affordability, the stress test itself is actually getting relatively easier at the moment because the spread between the qualifying rate and discounted mortgage rates is shrinking. Historically, the qualifying rate has been roughly 2.7% higher than the rates people actually pay. But because mortgage rates are pushing the minimum qualification rate above the 5.25% minimum for many borrowers, Canadians are now qualifying at rates just 2.0% higher than what they’ll actually pay. As you can see, this makes the stress test relatively easier than it was just a few months ago, but still tougher overall due to higher rates.

OSFI, the regulator that sets the mortgage stress testing rules, reviews the policy on an annual basis. At the next review on December 15th, 2022, OSFI could choose to raise the minimum qualifying rate to any number they see fit. If rates continue to rise at the pace they have been, it wouldn’t seem inappropriate for the minimum qualifying rate to be adjusted to 3% above the contracted rate or even higher. In that case, the stress test itself would be tougher, and not just because rates are rising. 

Do I need to worry about the stress test if I already own a home?

The stress test is aimed at new mortgages. If you already own a home and have a mortgage, you won’t be subjected to the stress test if you decide to renew with your current lender. If you want to refinance your mortgage or switch to a new lender, however, the stress test will apply.

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How can I maximize my mortgage affordability despite the stress test?

In theory, higher mortgage rates should translate to a decline in house prices. In practice, it’s unclear how soon prices will decline, and by how much. Consider these tips for maximizing your mortgage affordability despite the toughening stress test.

  • Raise your income: It’s easier said than done, but making more money can help you qualify for a bigger mortgage.Sometimes, it can help just to have your income look bigger on paper. For some reason, lenders only like income that comes from annual salaries. Hourly wages, commissions, bonuses, and self-employment income don’t get the same respect. If you have the option to trade these kinds of income for a bigger salary, it can help you look like a better candidate to the banks.
  • Save a bigger down payment: Making a larger down payment reduces the amount you need to borrow, and helps you save money on mortgage default insurance (often called CMHC insurance). Following our example above, you would qualify for a purchase price of $393,800 with a down payment of $39,380. If you could save an additional $51,980, your maximum purchase price would rise to $456,800 – a gain of $1.21 for every dollar you save.
  • Get a mortgage pre-approval: If you’re planning to buy a home in the next three or four months, getting pre-approved for a mortgage can help you shop with confidence. When you apply for pre-approval, your mortgage broker or lender will look at your financial situation and guarantee a maximum purchase price and interest rate for up to 120 days. If rates go down before you complete your purchase, you’ll get the lower rate. If rates go up, you’ll still get the rate you were pre-approved for.
  • Start with a variable-rate mortgage and convert to a fixed rate: If you want a fixed-rate mortgage but want to qualify for the maximum amount, you can start with a variable-rate mortgage to utilize the lower stress test rate and then convert to a fixed rate (with the same lender) after closing without having to pass the higher fixed-rate stress test. There is no penalty for doing this. Use caution with this method, because your lender can raise your mortgage rate at any time. Make sure you convert to a fixed-rate mortgage as soon as you can to avoid a situation where you’re potentially unable to afford your mortgage payments. 

The bottom line

The mortgage stress test is a useful tool to make sure you won’t be caught off guard by rising interest rates. Prepare yourself for a future with higher mortgage rates by saving a larger down payment and improving your income, if only for mortgage application purposes. When you’re ready to buy a home, ask your mortgage broker about getting a mortgage pre-approval to lock in the best mortgage rate and gain certainty about how much you can afford.

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