Understanding the mortgage stress test

As of June 1, 2021, a new mortgage stress test has come into play. Here’s what you should know before you apply for your next home loan:

The new rules that banks must follow are to protect you, the borrower. Interest rates have been so low, so it is easy to believe that the rates will not rise, but they will. Therefore the rules are in place to ensure that you will be able to afford your home when the rates eventually rise and not default on your mortgage payments which could end with you losing your home.

When applying for a mortgage, your credit score will determine how much you can borrow. The financial institution will then offer a mortgage interest rate corresponding to that score. In addition to the rate offered, it will make a future calculation based on a higher future rate increase of an additional percentile amount. For example, borrowing $500,000, with a rate of 1.78%, means that you’d need to prove that you can make payments of $2,981 per month (at 5.25%) though the payment would actually be less at $2,063. Previously the 5.25% pre-July 1 test guideline would have been 4.70%.

As a licensed mortgage provider, we are here to answer your questions.

Understanding mortgage rates

The influence of the Bank of Canada, in tandem with the markets, influence your mortgage rates. The following are excerpts from the Bank of Canada website:

Buying a home is probably the biggest purchase you’ll ever make. If you’re like most people, you won’t pay cash—you’ll borrow most of the money by taking out a mortgage. And over the life of the mortgage, you’ll pay a lot in interest. Small changes in interest rates can make a big difference in how much you’ll pay. So it’s important that you understand what determines the interest rate on your mortgage, even if you already own a home. Many factors go into the interest rate you pay. 1

Think of a mortgage as a product you buy. Any business that sells you something tries to make a profit. To do that, the price they charge for the product has to be higher than the cost to make it. A lender profits on your mortgage because you pay more in interest (the price it charges) than what they paid to borrow the money themselves (their funding cost).1

This funding cost makes up most of the interest rate on your mortgage. Other factors include your lender’s operating costs and how much the lender needs to cover the risk that you won’t repay the loan. But funding cost is the most important factor.1

So, what determines funding cost? The Bank of Canada doesn’t set mortgage rates. But it does have some impact on them. When the economy is strong, we may raise this rate to keep inflation from rising above our target. Likewise, when the economy is weak, we may lower our policy rate to keep inflation from falling below the target. Changes in the policy interest rate lead to similar changes in short-term interest rates. These include the prime rate, which is used by the banks as a basis for pricing variable-rate mortgages. A policy-rate change can also affect long-term interest rates, especially if people expect that change to be long-lasting.1

In the past, high and variable inflation eroded the value of money. In response, investors demanded higher interest rates to offset those effects. This increased funding costs for mortgage lenders. But since the Bank of Canada began targeting inflation in the 1990s, interest rates and uncertainty about future inflation have declined. As a result, funding costs are now much lower.1

Your past credit history and some of the features you choose for your mortgage determine how much risk lenders face when lending to you. More risk means a higher interest rate. 1

Repayment relates to your credit risk. The most important risk for the lender is that you won’t repay the loan. A high credit score can help lessen this concern, as it shows the lender you’ve been good at repaying your debts. So, you may pay a lower interest rate than those who have a lower score. 1

If your mortgage is worth more than 80 percent of the value of the home, you’ll have to buy mortgage default insurance. But since insurance protects the lender from the risk of default, you may get a lower interest rate than if you go for an uninsured mortgage with a bigger down payment. 1

Interest rate risk. Most mortgage loans in Canada are renegotiated every 5 years, but they can be as short as 6 months or as long as 10 years. The more often you renegotiate, the more often you face the risk that the new interest rate will be different from the old one. If you are more comfortable with having your rate fixed for as long as possible, prepare to pay a premium for that peace of mind. 1

Prepayment risk. The lender risks losing money if you repay your mortgage early—known as prepayment risk. That’s because the lender won’t be able to profit as much from the funds they raised, particularly if interest rates have dropped since the mortgage started. So, an “open” mortgage, which lets you repay all of the loan early, usually has a higher interest rate than a “closed” mortgage, which limits how much you can prepay. 1

Source: 1 Bank of Canada

How to prepare to qualify for a mortgage

When you apply for a mortgage, there are several questions that a lender may ask that you can prepare for. They will want information relating to:

The primary information they will need.

  1. Employment and income
  2. A summary of your outstanding debts
  3. Cash reserves, bank account cash, investments, and other assets
  4. The down payment that you have on the property you are purchasing and is it your own money
  5. Will the loan also be to consolidate any debts?
  6. What will be the use of the property?
  7. What is the equity you now have in your current home, if applicable?

Employment and income.

  • Who is your employer?
  • How much income do you make, and can you provide payment receipts/stubs?
  • How long have you been working at your job?
  • Is your income a salary or other income such as sales commission?

Your liabilities.

  • What are your outstanding debts?
  • What commitment level per month do you have to pay debts?
  • What is the cost per month for auto loans?
  • How much of your income goes to pay off credit cards, and what is the gross credit card debt?
  • How much money will be left after you pay for your down payment and closing costs?
  • If you are refinancing debts, how much debt will your mortgage cover and reduce your equity?

What you will use the real estate for:

  • Will this be your residence?
  • Will you rent a portion of the home out?
  • Is it an investment property?

Property type

  • A condominium?
  • A duplex?
  • A single dwelling?

Responses that can work in your favour:

  • I have steady employment with the same employer for two-plus years.
  • I carry little debt with a debt-to-income ratio of 25 per cent or less.
  • The mortgage is only for a home purchase.
  • My down payment of at least 30 per cent of the sales price with my own money.
  • The cash reserves will pay several months of the mortgage payments once the property closes.

Responses that can work against you:

  • Self-employed or contract worker.
  • High debt with credit cards maxed out, with a total debt-to-income ratio of more than 30 per cent.
  • The property will be renovated for rental use.
  • The liquid cash situation is tight once everything is paid after we close the deal.

Mortgage planning cautions

Mortgage planning cautions

  1. Don’t overburden your cash flow. North Americans are taking on far too much debt, partly influenced by lower borrowing costs. When money is cheap, people take on more debt; when interest rates rise, they reduce debt.
  2. Rates Rates Rates Please do your homework and check our mortgage rates. It is far too easy to take out or renew a mortgage from your local bank that you visit regularly. When you get a mortgage renewal letter from your current lender, work at negotiating a contract or comparing lenders who may have fewer restrictions plus at a competitive rate. A broker or lender may offer much lower rates. A few basis points can make a big difference when it comes to paying off a mortgage.
  3. As a mortgage specialist, I can help. For personalized financial advice, you should speak with a licensed mortgage broker to compare and sell mortgages. He or she will focus on your specific needs, which is just as crucial as a reasonable rate.
  4. Read the fine print. Blessings or potential problems can be ascertained in the details. Know what you’re signing. What are the prepayment options, late payment fees, and refinancing penalties? Is a variable rate mortgage convertible into a fixed rate? If so, how will the lender calculate the fixed rate?
  5. Maximize the frequency of your payments. Consider paying bi-monthly versus monthly to shorten your payment amortization period.
  6. Further, reduce your amortization period. After paying a mortgage for five years, try to reduce the amortization period by those five years. In this way, a 25-year mortgage amortization period is reduced to 20 years.
  7. Know your mortgage facts. It is essential to know the facts about your current mortgage and one that you may renew. Check out what your interest rate is and what your monthly payments are per month. Find out when your mortgage is up for renewal. In certain cases, there may be a penalty for getting out of your mortgage early or restrictions. A change in your rate, such as moving from a variable rate to a fixed rate, might be a good move. Know your total income, liabilities, debt repayment costs and expenses. The lender will then determine how much you can afford. A good rule of thumb is that your mortgage payments should not exceed more than 40% of your net income.


A Mortgage Shoppers To-Do List

Before shopping for a new home, getting a preapproved mortgage lined up several weeks before closing is essential; you also want to look at what mortgage brokerages are offering. Often you can find a competitive rate with excellent terms provided by an advisor who offers mortgages.

Often the mortgage rates advertised by your bank are higher than rates that a mortgage broker can find. Also, avoid restrictions on making lump-sum payments or high fees if you need to leave the mortgage before renewal.

Your checklist:

  • If you own a current home, get it evaluated
  • Get your credit score from Equifax or allow a brokerage to acquire it
  • Taxes and assessments from the last two years
  • Careful accounting of your household income
  • Assess your liabilities, such as credit cards and loans
  • Assess your assets held in investments and savings accounts
  • Have enough for a down payment on hand
  • Also, have enough cash for closing expenses for legal fees, mortgage and title insurance, and transfer taxes.
  • Budget for extras such as buying new appliances or condo fees if applicable
  • Research the meaning of mortgage contract terms as it applies to each specific company offering a lower rate. Know about:
    • Variable rates
    • Fixed rates
    • Open versus closed mortgage
  • A line of credit works well if you are going to renovate.

Establishing your Mortgage down payment


Establishing your Mortgage down payment

Accumulating a down payment for a first-time homebuyer or a reno can be a challenge. Many younger adults have other obligations such as student loans, rent, and basic monthly expenses.

What are some tactical options to enable you to acquire a down payment:

  1. First, consider what you can afford By calculating what you truly can afford for a down payment or a renovation plan if you are considering staying in your current home, we can look at the refinancing scenarios. By calculating your post-reno value, you may be eligible for more mortgage money.
  2. Your RRSP may have the answer The Home Buyers’ Program (HBP) allows first-time home buyers up to $25,000 withdrawal (double that for a couple to $50,000). This manoeuvre is tax-free from accessible RRSPs. Consider that you will be taking on the responsibility of establishing a repayment plan. Canada Revenue Agency (CRA) allows the HBP insofar as you pay back your RRSP funds at approximately 1/15 of the funds borrowed per year, over 15 years. If those monies are not paid back on time, they will be taxed as income at your going rate.
  3. A tax-free gift of money Gifted funds from a parent or a blood relative may provide a downpayment. A written document must be provided, indicating that the funds are a gift without any requirement to pay back the money.
  4. A loan from a friend or relative Perhaps a grandparent or a friend can loan you the down payment with a fair interest rate, with a manageable repayment agreement. Consider also using other borrowed funds or using an unsecured line of credit.
  5. Consider a lower-priced starter home Consider a fixer-upper or a lower priced first home. With current lower interest rates, pay down the mortgage as quickly as possible. Then with your good credit rating, apply your new equity to purchase your dream home.

The necessity of a licensed mortgage agent

Many Canadians are stunned by what has happened to the Canadian Real Estate market in our key cities. Some think it has been wealthy foreigners buying up our best houses and lands. Others believe the problem is due to the misdirected legislation federally and provincially — an absence of reasonable laws designed to protect the home prices for Canadian citizens from being artificially inflated. Still, others think it is the low-interest environment offering near-zero interest rates responsible for the crazy inflation. Or is due to houses being quickly flipped, increasing the value sometimes by up to or more than double what the home initially agreed to be sold for? During the pandemic, there was an extreme bidding up of house prices. It may be a mixture of all of the above.

Many intense studies are underway. Josh Gordon of Simon Fraser University has studied all potential causes. Historically, there is a lack of essential data available, despite being in an age when data influences our life decisions.

Michael Babad, of the Globe and Mail, published as far back as Apr. 21, 2016, that millennials — children of baby boomers — find it difficult, or near-impossible financially, to live in Vancouver or Toronto. 

Millennials who are just starting out and want to buy a home may find it hard to afford a mortgage. Michael Babad goes on to note that: 

“Paying for a house has become so difficult that saving for a down payment takes years in Toronto and possibly decades in Vancouver, new research suggests: Toronto is troublesome, and Vancouver positively out of sight, according to a National Bank Financial study, although it is far easier in other Canadian markets such as Montreal and Calgary” and “in Toronto and Vancouver, affordability for homes other than condos is the worst in National Bank records dating back to 2000, based on first-quarter data”.

National Bank’s senior economist Matthieu Arseneau and associate economist Kyle Dahms analyzed comparative real estate prices and increases, in contrast to incomes, required down payments and the mortgage payment required as a percentage of income (referred to as the MPPI). Vancouver and Toronto markets pop off the grid compared to other prices.

Based on the time it takes to save a down payment for a single-detached house, semi or townhome, you might consider using a mortgage specialist.

National Bank’s senior economist Matthieu Arseneau and associate economist Kyle Dahms, analyzed comparative real estate prices and increases, in contrast to incomes, required down payments and the mortgage payment required as a percentage of income (referred to as the MPPI). Vancouver and Toronto markets pop off the grid compared to other prices.

Based on the time it takes to save a down payment for a single-detached house, semi or townhome you might consider using a mortgage specialist.

We are only a click away. Contact us today and we will be happy to help you.

Understanding mortgage amortization

Amortisation refers to the number of years it will take to repay your mortgage in full. Based on your down payment and current legislation, amortisation periods can run up to 30 years.

Shorter amortisation periods allow you to accelerate paying off your mortgage. The other advantage is that you will pay less interest the more the timeline shortens. The tradeoff is that you will pay more for your monthly payment.

The mortgage payment and method need to unify with your overall financial plan. For example, a mortgage of $400,000 at an average fixed rate of 5% and a 30-year amortisation will have a $2,134 monthly payment, and you will pay $368,506 interest over the 30 years. Reducing the period to 25 years, you’ll pay more at $2,326, but your total interest expense will be reduced to $297,924, saving $70,882.

In our calculator section on this website, we have mortgage calculators, which may prove helpful for planning.

Homeowner Mortgage Default Insurance

Canada Mortgage and Housing Corporation (CMHC) provides Homeowner Mortgage Loan Insurance, which is required by law to insure lenders against default on high-ratio mortgages.

A high-ratio mortgage This a mortgage with a loan value of more than 80% of the value of the home purchase price (the borrow puts down under 20%). 

Note: Bear in mind, legislation may change from the date of this article. Talk to your mortgage agent for an update.

A conventional mortgage This is a mortgage with more than a 20% down payment, which means it has less than 80% of a loan to value ratio — less than an 80% stake in the home’s equity value when purchased.

Homeowner Mortgage Loan Insurance required by law

When a person is buying a home, a new homeowner, in most cases, takes out a mortgage. A mortgage is a loan taken out by a borrower referred to as the mortgagor from a lending institution, referred to as the mortgagee. The property is used as security for the debt. Homeowner Mortgage Loan Insurance is required by law to insure lenders against default on a high-ratio mortgage.

You repay the principal amount loaned to you The principal is the actual loan amount that the mortgagor is expected to repay to the mortgagee (loaning institution). Additionally, the interest is paid over the repayment period (amortization) of the mortgage.

A mortgage is a fully secured loan A mortgage is a fully secured form of financing. Thus, the interest you pay is usually less than with most other types of financing, such as when you buy a car or use a credit card. Once you have built up equity value in your home, a mortgage can finance many different things, including:

  • Constructing a new home
  • Purchasing an existing home
  • Consolidation of debts
  • Financing a renovation
  • Financing the purchase of other investments
  • Financing the purchase of investment property

How do you qualify for Homeowner Mortgage Loan Insurance?

  • The home is in Canada.
  • For CMHC-insured mortgage loans, the maximum purchase price or improved property value must be below $1,000,000. Note: Legislation may have or change at any time.

Consideration to How Much Can You Afford

Before you begin shopping for a home, it’s essential to know how much you can afford to spend on homeownership. You will want to plan ahead for the various expenses related to homeownership. In addition to purchasing the home, other significant expenses include heating, property taxes, home maintenance, and renovation as required. Two simple rules can help you figure out how much you can realistically pay for a home. You must understand these rules to understand if you will be able to get a mortgage.

Ask your mortgage agent what the typical minimum down payment is currently for the purchase price of the dwelling, depending on the dwelling type.

  • Single-family and two-unit dwellings 
  • Three- or four-unit dwellings 

Typically, the minimum down payment comes from personally owned resources. However, a down payment gift from an immediate relative is acceptable for dwellings of 1 to 4 units. For eligible borrowers, additional sources of down payment, such as lender incentives and borrowed funds, are also permitted. Check with your lender for qualifying criteria and availability.

Your total monthly housing costs, including Principal, Interest, property Taxes, Heating (PITH), the annual site lease in the case of leasehold tenure and 50% of applicable condominium fees, shouldn’t represent more than 32% of your gross household income (Gross Debt Service (GDS) ratio). Use the GDS form to calculate how much you can afford in housing costs to be eligible.

Your total debt load shouldn’t be more than 40% of your gross household income. The Total Debt Service (TDS) ratio is your PITH + the annual site lease in the case of leasehold tenure and 50% of condominium fees (if applicable) + payments on all other debt / gross annual household income. Add up your costs and determine your Total Debt Service ratio using the TDS form.

It would be best also to consider closing costs (for example, legal and land transfer fees) equivalent to 1.5% to 4% of the purchase price. Many first-time buyers are surprised by these costs. 

Closing costs include but are not limited to one-time items such as lawyer fees, GST and PST as applicable, land transfer tax if applicable, adjustments, etc., to allow you to complete the house purchase.

Other requirements may apply and are subject to change.

Definitions: Since the buyer/borrower is pledging the property, he/she is “mortgaging” the property and is known as the “mortgagor”. The lender is the recipient of the pledge and therefore is the “mortgagee”. The mortgagor mortgages the property to the mortgagee.

Source: © Adviceon ® and CMHC

Understanding Variable Mortgages and Interest Rate Increases

Many people prefer not to risk not knowing if their mortgage rate will climb higher due to rising interest rates. Many on a fixed budget want to reside in their home peacefully, not worrying about the potential for increasing rates. We all have to understand our risk tolerance on the one hand and our desire for practical frugality on the other.

When the bank rate rises .25%, variable rates can climb higher. Variables are flexible in the financial market. As such, the market affects most variable mortgages by a significantly higher extrapolated percentage of increase (factors which are applied differ among banks). For this reason in an economic environment of rising interest rates, it may be in your best interest to review and possibly reform variable mortgages or interest-only mortgages to a more guaranteed period of five years or higher.
Do the math, asking yourself if you are sure you want to proceed at a fixed rate.

The upside is that with a five-year term, you can know your expense precisely for the entire period. Conversely, the upside of the added risk of the variable rate is that you may not see an increase (as we do now in several banks) and you might even see a fluctuating decrease of rate.

Give me a call, or contact me via my website to discuss your options.