One of the most important lessons on handling money is always to have your finances in check. This is the reason why a lot of financial professionals suggest keeping tabs on your spending, having emergency funds, and only taking out loans you can repay.
We can apply the same principle when taking out a mortgage. We need to ensure that we can make our repayments before signing a deal. Likewise, financial institutions would want to make sure that you can handle the mortgage you’ve taken out even if emergencies happen. In finance lingo, we call this the stress test.
In the context of mortgages, a mortgage stress test analyzes whether a particular borrower can afford to make mortgage repayments under certain financial situations. If you’re a Canadian resident looking to buy a home, you’ll likely be subjected to a stress test before you’re able to secure a mortgage.
But how do mortgage stress tests work? And what should you do to prepare for it?
In this article, we’ll share with you all that you need to know about mortgage stress tests in Canada. Sit back, take notes, and thank us later.
In 2017, the Canadian Government launched a mortgage stress test for everyone who wants to apply or reapply for a home loan. This test will assess if potential borrowers are qualified for a home mortgage based on their cash inflow and outflow. Everyone is required to go through the stress test — yup, even if you have a good credit record and put down a 20% downpayment.
The mortgage stress test is unlike other tests where you have to study to be able to answer everything. What we mean by “preparation” is to check all your documents and credit records before taking the test. Before anything else, it would be best to consult a real estate agent or to at least research on Canada’s best interest rates for the mortgage you have in mind. Websites like Rate Genie provide information about this matter.
Passing the Test: Key Metrics
To pass the test, here are two key metrics that lenders use: gross debt service ratio (GDS) and total debt service ratio (TDS).
- Gross debt service ratio (GDS) – GDS is the percentage of your income (before tax deductions) required to pay housing costs. Your chosen lender will look at your stress-tested monthly mortgage payment, condo fees (if applicable), utility bills, and property taxes. The lenders will sum up all of these costs and divide them by your gross monthly income. The ideal percentage is 32% and below.
- Total debt service ratio (TDS) – Since you’re aiming to get approved for a home loan, your lenders will need to check all your debts through TDS. The total debt service ratio is the amount deducted from your income that’s allotted for paying ALL your debts. These debts may include personal or payday loans, student loans, credit cards, and vehicle loans. Ideally, your TDS should not exceed 42% of your gross monthly pay to get approved.
To give you a better idea, here’s an example:
If your mortgage amounts to $400,000 and your total monthly housing costs $3,000, you’d need a pre-tax income of at least $9,375 or $112,500 annually. Based on that income, your outstanding debt should not exceed $3,937.50 per month (including your mortgage payment) to have a TDS of 42% or less.
Mortgage Stress Test: Other Important Factors
Other essential preparations for the mortgage stress test include:
- Pay outstanding debts. It’s a no-brainer that anyone should repay as many of their existing debts as possible before applying for a mortgage. Remember: we’re aiming for a TDS of less than 42%, and settling some of your outstanding debts will lessen your TDS percentage. Besides, taking out a mortgage when you still have a lot of other debts to pay will affect your ability to make repayments on time. Borrowers who keep on getting loans (beyond what they can comfortably afford) are more likely to get buried in debt.
- Apply for a small loan amount first. You should assess your financial capabilities before applying for a mortgage loan. Are you really capable of paying $700,000 for a house? Will you be able to religiously make timely repayments for the next 10 or 20 years? If you’re in dire need of a new home, perhaps you can consider getting a $500,000 home that’s simpler instead? The key here is to be realistic about what you can and can’t afford. If you can manage to get a cheaper home without affecting your family’s comfort level too drastically, then it’s best to avoid the potential stress that comes with paying off a fancy house.
- Get ready for increasing interest rates. Interest rates may also increase over time. You might have to throw in an additional $300 per month (or even higher) to your monthly payments because of this. And if that happens, will you be able to afford it? Again, try assessing your financial situation and ask yourself if you can afford to pay extra dollars per month in case the interest increases. Mortgages that have variable rates are likely to be impacted by the rise of general interest rates since they’re based on the prime rate.
How to avoid the mortgage stress test?
Stress tests are mandatory for all federally-regulated banks. However, private lenders and credit unions do not operate under Canada’s Office of the Superintendent of Financial Institutions (OSFI). This means they’re not required to assess their mortgage applicants through the stress test.
So if you want to avoid this test, you can always opt for private lenders. That said, the tips we’ve outlined above could still help you even if you choose to go with private institutions to get a mortgage. The aforementioned practices can help you improve your financial handling, credit history, and credit score, which are factors used by private lenders when deciding on your mortgage’s approval, terms, and interest rate.
The Bottom Line
With the above in mind, it’s important to remember that a mortgage stress test isn’t just an obstacle that potential homeowners should “pass,” but something they should take seriously. It’s a reflection of your financial situation and habits. Though it may seem like a hindrance to homeownership, the stress test actually helps you avoid falling into a financial hole in the future.