NEW LENDING RULES... and the "Stress Test"

July 24, 2019 - This week, the Bank of Canada just reduced its Stress Test rates very slightly, perhaps as a signal to the federal government that it agrees with sentiments across the country that they would like to see an end to this very damaging program.
If you have a 50,000 income, and put 20% down on a home, you now have an extra 4,000 purchasing power. If your combined income is 10,000 and you put 20% on a home, you now have an extra 8,400 purchasing power.

Canadians looking into mortgages will newly have to prove that they would be able to cope with interest rates substantially higher than their contract rate after January 1st, 2018.  This could affect you whether you're looking to get into a new mortgage, or whether you want to renew or refinance an existing one.  

New rules by Canada’s federal financial regulator mean that even the borrowers with a down payment of 20 per cent or more on their home purchase will now face the stress test alongside borrowers with smaller down payments.

What's the "stress test", you ask? 
The test simply forces you qualify at a higher rate of interest, which forces some breathing room into your budget, so that you'll be able to afford an increase in interest rates when the time comes.  If you've been keeping up with the news feeds, maybe you'll agree that the feds seem very keen to increase interest rates lately.  In fact, every time Stephen Poloz says he's not going to hike interest rates again just yet, you can almost hear the wails of disappointment coming from our Nation's Capital.  The juggernaut just south of our border is growing at a pace almost 3 times greater than ours, so you can understand the pressure they're feeling to keep up with the Hatfields & McCoys.

What's the problem?  You won't qualify for as much money to buy a home.  In fact, it could be a lot less money than you could qualify for previously, which is a big deal where homes in at least a few places in Canada cost a lot more money this year than they used to.  

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The stress test has been like this since January 2017 for applicants who have only been able to come up with down payments of less than 20% for their homes.  The smaller down payments would also require that they pay for mortgage default insurance.  The principle behind this is pretty simple:  If you haven't been able to save up a 20% down payment, then your financial situation is presumably a little more tenuous than someone who has, and your loan is going to be larger, therefore you might have more difficulty affording a mortgage payment alongside your other bills, which means that anyone loaning you a lot of money would like a guarantee that they'll be able to get their money back if there's some sort of dramatic change in your financial situation.  In this case, the dramatic change we're talking about just might be an increase in interest rates.  Yes, it's a Catch-22.  It might be a different world if the feds were intent on keeping interest rates low, but it seems that was yesterday's philosophy.  There are good points and bad about keeping interest rates low or high, but when it comes to your mortgage, lower is surely where we'd all like to be.

Explaining a Mortgage: the very short version
Let's understand a "mortgage" very briefly before continuing. The bank isn't giving you a mortgage... it's the opposite.  Putting your home up as security for a loan means that you're giving the bank a mortgage over your home.  (It's only confusing because you haven't actually paid for the home you're using as security for the loan).  In the old days, you could think of it as handing over the deed to your home in exchange for a loan... ie. you've "mortgaged" your home.  We don't have "deeds" in the modern system, but the premise works for the analogy.  If you can afford to make a big down payment or if your payments represent a very small piece of your income, then the bank will be very comfortable with the arrangement.  If your financial situation is not quite so robust, they just might ask for some assurance, which we will call "insurance".  The threshold for this insurance requirement has been set at a minimum 20% down payment.  If you can't put down at least 20% on your home, then you'll need to insure your mortgage.  This is why you hear about insured vs. uninsured mortgages in the stats.

Note: The requirement that you must put down at least 5% to get a mortgage has nothing to do with this.

Explaining Insured Mortgages: the very short version
Mortgage Insurance guarantees that the lender is made whole in a bad situation.  You agree to pay for it as a condition of your loan.  Generally looked at as a great thing, default insurance has made banks more willing to grant larger loans to consumers, and without it you could argue that banks might have been reluctant to help many people buy a home in the first place. 

In the old, old, old days the bank might actually hold onto your deed and not let you live in the house until your loan had been fully repaid, but it's not necessary in today's financial system.  Ownership is recorded in a different way that is much less susceptible to frauds or complications like, "which shoebox did I put that dang deed in anyway?"... but people still default on their loans from time to time.  If the bank incurs a loss because of these defaults, the insurance makes them whole.  This is not to be confused with Mortgage Payment Insurance, which would cover your monthly payments in the event of an injury or loss of income.  Totally different animals and completely unrelated with one another.  One is for the banks and one is for you, although you're the one paying for both of them. 

*Always seek professional advice before relying on any information you find online*
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Mortgage default insurance is expensive.  Typically 0.5% up to 4% of the value of the home, annually.  It's more expensive with high ratio mortgages.  You're able to ask your lender for the insurance requirement to be removed once you have realized at least 20% of the equity in your home, based upon the original purchase price.  Until that time, It all goes onto your monthly payment, but you could be looking at hundreds of dollars every month.

* Always seek professional advice before relying on any information you find online *.
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Aiming at Household Debt
Since 2008, Ottawa has made a series of regulatory tweaks aimed at limiting the amount of debt that Canadian consumers and financial institutions are allowed to assume.  There have been six tweaks so far, the new lending rules being tweak number seven... and this one just might turn out to be "the big bang". 

The rules will effect people who would have qualified for a mortgage under the old rules, but around 100,000 Canadian home buyers will likely fail the stress test for an equally large loan today.  You're being forced to qualify for a larger interest rate than is currently available because the feds expect it'll be going up and they don't want you to over-extend yourself.  Around 10% of homeowners with uninsured mortgages who bought in the last year or so wouldn't have even been able to qualify under the new standards... and that's just the group who could actually afford the 20% down payment.

The stress test means that financial institutions will vet your mortgage application by using a minimum qualifying rate equal to the greater of the Bank of Canada’s 5-year Benchmark rate (currently 5.34 per cent) or their contractual rate plus two percentage points.  The Bank of Canada sets the benchmark rate based upon the 5 year lending rates of the big banks.  Note that many loans are offered well below the Benchmark Rate.  5-year rates in the neighbourhood of 3% are pretty common right now...  
3% plus 2% equals 5%. Therefore, you'll have to qualify at 5% under the new rules.  
* ALWAYS ask for professional advice before relying on any information you find online *

If you’re going be house-hunting next year, this may force you to settle for a much less expensive home than you would be able to buy today. 

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If you’re renewing your mortgage next year
Lenders don’t have to apply the stress test to clients renewing an existing mortgage, which is clearly a good thing for people who have purchased a little out of their league... seemingly an enormous issue in Vancouver and Toronto.  The down side is that you may find yourself having to stick with your current lender at a rate that's not very competitive if you're unable to meet the stress test with a new lender.  Maybe it would have been nice to be able to shop around for a better rate?  

Refinancing Your Mortgage
If you’re planning on refinancing your mortgage, you’ll have to qualify according to the higher stress test rates rather than your existing contractual mortgage rate.

For example:  you bought a $400,000 home and have a $100,000 mortgage balance left. You’d like to borrow $50,000 more for a renovation. You have a five year fixed-rate mortgage at 3.3 per cent. 
- Under the old rules, your lender would make sure that you can take on a $150,000 loan at 3.3 per cent.
- Under the new rules, your lender will have to make sure that you can take on that $150,000 loan using a 5.3 per cent rate because you're refinancing.  

The Office of the Superintendent of Financial Institutions (OSFI) rules only apply to federally regulated financial institutions, and this means Canadians might be able to continue borrowing without a stress test if they turn to provincially-regulated credit unions.  In the past, however, credit unions have voluntarily adopted new federal standards on mortgage rates “pretty quickly”, although clearly they will have the freedom to make some exceptions.  Your Mortgage Advisor will be a great resource with respect to this, and I always recommend a Mortgage Advisor to my clients.

The stress test measures only one of three risk metrics looked at by lenders.  Essentially, it ensures that borrowers’ housing expenses compared to their income remain below a certain threshold, even in the event of a sizable increase in interest rates.   Important to note that when evaluating a borrower, financial institutions also look at the size of the loan compared to the price of the house, and also at credit scores.

A credit union that has voluntarily adopted the stress test, might make an exception for a family with very strong credit scores and a down payment considerably higher than 20 per cent, even if they fail to qualify under the new rules by a small margin.  Credit Unions have that freedom. 

These could be important options to consider when working with your Mortgage Specialist or Financial Advisor.  You just might find that you still have options!  
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