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New mortgage rules: how to stress test your mortgage

New mortgage rules: how to stress test your mortgage

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New mortgage rules introduced in 2018 require all Canadian home buyers to undergo a mortgage stress test – even if you make a down payment of 20% or more1. Previously you would only have to stress test your mortgage if you made a down payment of less than 20%.

Why should you care?

If you’re buying a home the new mortgage rules will have a direct effect on how much home you can afford. You’ll have to prove that you could still make your monthly mortgage payments if interest rates were to rise in the future. Already have a mortgage? You’ll face a mortgage stress test if you refinance your home, take out a home owner line of credit, or switch to a new lender (but not if you renew with the same lender).

In light of these changes, we conducted the 2018 BMO Home Buying Survey to find out how Canadians feel about the new mortgage stress test rule, the future state of interest rates, and rising debt. You may be surprised by the results.

What are the new mortgage rules?

Basically the new mortgage rules mean that you’ll have to pass a test. Put away your pencil, it’s not that type of test. It’s called a “stress test” and it’s simpler than the name might imply. The new stress test means that you’ll have to qualify for your mortgage using the “minimum qualifying rate.”

How the stress test rate is calculated

For uninsured home buyers (anyone who qualifies with a down payment of 20% or more) the minimum qualifying rate is based on either the Bank of Canada’s five-year benchmark rate (5.14% at the time of writing) or the rate offered by your lender plus 2% – whichever is higher. Buyers with default insured mortgages (i.e. anyone who makes a down payment of less than 20%) must qualify using either the Bank of Canada five-year benchmark rate, or the rate offered by your lender (without adding the extra 2%) – whichever is higher.

So if your lender offers a rate of 2.99%, you’ll have to use the 5.14% benchmark rate in your stress test. If you make a 20% down payment and your lender offers a rate of 3.49%, you’ll have to qualify using a rate of 5.49%.

Although the new mortgage rules are supposed to protect the Canadian housing industry (and make sure that Canadians are spending within their means), the changes also mean that you might have to settle for a lower budget.
For example: Let’s say you have a household income of $87,000 and made a down payment of 20%. Before the new rules, you may have been able to afford a maximum purchase price of $508,069 (based on a 2.99% rate).2 Now, because of the 2018 mortgage rules, you’ll have to qualify for a rate of 5.14%. This means you may only be able to afford a maximum purchase price of $393,716, which is 22.5% less than under the previous rules.

New mortgage rules - maximum home affordability

table of 2018 maximum home affordability
Calculated using a household income of $80,940, down payment of 20%, over a 30-year amortization period, assuming a $201 monthly heating cost and $3,000 yearly property tax.

Mortgage interest rates “are going to go up” according to Canadians

Despite the frustration of some Canadians, the new mortgage rules came at a good time. Mortgage rates are expected to rise, and this test will help you make sure you don’t over-extend yourself.

According the 2018 BMO Home Owners Survey, 76% of Canadians think interest rates are going to go up, 36% think that rates are “going to go up soon” and 23% think rates will continue to rise after the next increase.

New home buyers

When asked about their choice of mortgage – that is, fixed or variable – new home buyers were influenced by rising mortgage interest rates. In fact only 13% said changing interest rates “would not have any influence” on the type of mortgage they planned on getting, while 51% would decide which type of mortgage they would select based on rates, 30% were still “more likely to go for fixed rate mortgage” and 5% would opt for a variable rate mortgage.

Mortgage holders

New home buyers aren’t the only people affected by higher mortgage rates. Anyone with a variable rate mortgage (25% of mortgage holders) will feel the impact of higher rates immediately (because their mortgage rate is tied directly to the prime rate). Homeowners with fixed rate terms (69% of mortgage holders) will continue paying lower rates until their current term ends but, after that, they should prepare for their mortgage rate to rise (6% of mortgage holders were unsure whether they had a fixed or variable rate mortgage).3

2018 BMO Home Owner's Survey - What type of mortgage do you have?

pie chart of 2018 bmo home owners survey results for type of mortgage
Although rates are changing, 76% of current mortgage holders “do not want to change the type of mortgage they have.”

Stress testing by the numbers

All Canadians will be affected by changing interest rates, whether you’re a prospective home buyer, or already have a mortgage. Despite this, only 47% of potential home buyers “intend to personally stress test their mortgage payments to ensure they are prepared in case rates go up” with 13% “not planning to at all,” 21% “unsure,” and 18% “not aware what stress testing is.”

Regardless, as of January 2018, all new home buyers are required to stress their mortgage.

How to stress test your mortgage

To see how rising interest rates might affect your mortgage payments simply apply the Bank of Canada's five-year benchmark rate (currently 5.14%), or the rate offered by your bank plus 2%, to your current mortgage using the BMO Mortgage Calculator.

Say you bought a $726,000 home with a $50,000 down payment at 2.99%. Your current monthly mortgage payment would be $3,328. Now, if you were to “stress-test” your mortgage, you’d apply the minimum stress test rate of 5.14%, which means that, to pay off the same principal amount as the previous rate, your monthly mortgage payment would balloon to $4,292 (a 29% increase!). Basically, you want to show that you could still handle your payments if rates were to rise.

New mortgage rules - monthly mortgage payments

table of 2018 maximum home affordability
Rates may not actually go that high overnight, but an increase of one or two percentage points over a longer period of time is a real possibility.

Most variable rate mortgage providers in Canada won’t increase your payments straight away. Instead, you’ll pay the same amount as before the rate increase, but less of each payment would go towards the principle. That means, in order to pay off your mortgage in the agreed-upon amortization period, you might have to make a tough choice. Here are your options:
  • Increase your monthly payments: You could either increase your monthly payments immediately, or wait until your term ends (but it’s a good idea to increase your monthly payments sooner rather than later – if you can afford it).
  • Make a lump sum payment (or multiple payments): Making a lump payment compensates for the fact that you’re paying off less of your principal each month. You could make this payment pretty much any time, but the sooner the better.
  • Do nothing: You could continue to pay the same regular payments as before the rate increase (with less of each payment going towards your principal) and wait until your term ends. Once your term ends, however, you’ll have to either increase your monthly payments, or make a lump sum payment to ensure that you pay off your mortgage by the end of your amortization period.
Deciding which option is right for you is a big decision and one that you should consider making with the help of a professional.

Even in the best of circumstances, a large increase in mortgage rates could prove to be a lot to handle. If your household brings in $6,000 per month after taxes and your mortgage payment increased to $4,292 then you’d be spending over 71% of your monthly income on mortgage payments alone.

Spending that much on your mortgage can leave you in a vulnerable financial position – and that’s before we take debt into account.

Debt stress test

Of those surveyed in the 2018 BMO Home Owners Survey, 83% have debt. Here’s how it breaks down: 13% claimed they have “a great deal of debt,” 42% had “some debt” and 28% said they “have little debt.”

Mortgages are a major source of debt as they contributed to 76%“of the home owners’ debt while the rest is split between mortgage and other sources.” Gen Xers have the most debt of all those surveyed and 15% of this demographic believe they have “a great deal” of debt.

2018 BMO Home Owners Survey - Which of the following describes your perception of your current debt?

debt levels survey result

Budget for higher mortgage interest rates

Because mortgages make up such a large proportion of Canadians’ debt, higher mortgage rates could place serious strain on households across the country. To help prepare for higher mortgage interest rates, you may want to create a monthly budget (that is, if you don’t have one already).

First, stress test your mortgage using the BMO Mortgage Calculator to find how much your monthly mortgage payments could change. Then add your other debt payments (like student loans), maintenance costs, and property taxes – as well as general bills and living expenses – to make sure you can cover it all.

The bottom line

If you’re applying for a mortgage, you’ll have to pass the new mortgage stress test. This could mean you’ll have to settle for a smaller house, move to a neighbourhood that’s not your first choice, or be forced to stick with your current lender. Regardless of whether or not you’re required to take a stress test, it’s still a good idea to take the opportunity to make sure your personal finances can handle higher mortgage interest rates.

You’re not on your own

Navigating the new mortgage rules and rising interest rates can be complicated, but you don’t have to do it alone. To talk through your options, get in touch with a BMO Mortgage Specialist today.

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