Mortgage Stress Test Explained: What It Is and How It Works

Every smart home buyer knows it’s not just the asking price that matters; it’s whether you can actually afford it. The mortgage stress test was introduced in 2018 to check that. Read our “mortgage stress test explained” guide to understand how it works, what rates lenders use, how it impacts your borrowing power, and how to prepare for it.

What Is the Mortgage Stress Test?

The mortgage stress test in Canada makes sure you can afford your mortgage payments if interest rates rise. Lenders don’t just look at your current rate; they test your ability to pay at a higher qualifying rate (your rate plus 2.0% or 5.25%, whichever is higher).

• Example? If your mortgage rate is 4.5%, your mortgage qualifying rate will be 6.5%, ensuring your budget can handle future rate hikes. But if the mortgage is 3%, the qualifying rate will be 5.25%.
• Why does it exist? Changes in the economy and interest rates are inevitable. This test protects homebuyers from taking on more than they can afford, and keeps the housing market stable.
• What’s its background? OSFI introduced it in 2018 under Guideline B‑20, stating that it’s going to be applied to most federally regulated lenders, including banks and credit unions.

How the Mortgage Stress Test Works

Lenders calculate the stress test rate (your rate plus 2.0% or 5.25%) to see whether you’ll be able to afford higher payments or not. Once lenders have the qualifying rate, they calculate a hypothetical monthly payment using that rate. This increases the payment on paper, but you’ll still pay the actual lower rate when approved.

Lenders also assess your affordability by looking at two key ratios:

• Gross Debt Service (GDS): The share of your gross income that would go to housing costs (mortgage payment at the stress test rate, property taxes, heat, etc.). GDS shouldn’t make up more than 39% of your pre-tax income.
• Total Debt Service (TDS): All monthly debt payments (mortgage at the stress test level plus other debts) compared to your income. TDS shouldn’t exceed 44% of your pre-tax income.

If the ratios are within acceptable ranges, your mortgage will be approved. If not, you either need more income, less debt, a larger borrowed down payment, or look for a less expensive property.

Who Needs to Pass the Mortgage Stress Test?

Now that you know how mortgage stress test works, let’s see who needs to pass it. The people who need to pass this test include:

• First-time homebuyers, no matter the rate type or term length
• Buyers refinancing their mortgage
• Borrowers switching lenders and refinancing
• Borrowers who take out a second mortgage
• Those who apply for a home equity line of credit

There are a few exceptions, too. According to mortgage stress test rules, you don’t need an assessment for:

• Mortgage renewals with the same lender
• Uninsured mortgage renewals with a new lender at the same loan amount and mortgage amortization (a straight switch); insured mortgages already have a pass)
• Certain home equity lines of credit under existing arrangements

Mortgage Stress Test Rates Explained

With the mortgage stress test explained, let’s take a closer look at its rates. We saw that lenders consider the higher rate (mortgage rate plus 2.0% or 5.25%) to see if you can afford your mortgage. This will be your mortgage qualifying rate.

Other important rates and numbers in this calculation include:

• Contract rate: The lower rate you’ll pay on your mortgage; it’s the rate that the bank/lender offers.
• Benchmark rate: It’s essentially the qualifying rate, a higher rate that’s used to ensure affordability in case interest rates rise.
• Buffer: It’s a safety margin showing borrowers can absorb some negative impacts on their finances. It’s currently set at 2.0%.
• Floor: Currently set at 5.25%, it accounts for risks that can emerge from changes in the economy.

How the Stress Test Affects Borrowing Power

The mortgage stress test in Canada affects both first-time buyers and other borrowers. Overall, it reduces borrowing power (up to 25%, according to some sources) and loan sizes. It results in safer, but smaller mortgages.

Total mortgage may be lower than expected, as borrowers are often approved for less than the maximum amount their income suggests. First-time homebuyers may need more money for a down payment or a higher income in order to qualify, too.

FAQ

What is the mortgage stress test rate?

It’s a test to determine whether you’ll be able to afford your mortgage in case interest rates rise.

Does the stress test apply to mortgage renewals?

If you renew your mortgage with the same lender or choose a new lender at the same loan amount and amortization, you don’t need to pass this test.

Can I avoid the mortgage stress test?

If you can find yourself among the mortgage stress test rules’ exceptions, yes. Some lenders also offer mortgage products designed to avoid the stress test.

How can I prepare for the mortgage stress test?

Calculate relevant variables (including your gross income and credit score) and assess your situation. Pay as much as you can and take saving and budgeting seriously.

If you’re a first-time buyer, hire professional home inspectors from Houmse to reveal repair costs upfront to get a better deal.

Final Thoughts: Understanding the Mortgage Stress Test

Knowing the mortgage stress test helps you plan your home purchase realistically, so you can cover your mortgage, taxes, and other costs without stretching your budget.

But there’s something that not all “mortgage stress test explained” articles mention: this test only considers one point in time. So, you need to consider the cost of living over time as well to make smarter mortgage decisions.