OPINION: The case for a simple fixed Canadian mortgage stress test
At Mortgage Sandbox, we believe the current Canadian mortgage stress test has some unintended negative impacts. The test is confusing to consumers and contributes to home price volatility and we propose a simpler stress test solution that resolves both of these issues.
The stress test is intended to test whether Canadian borrowers would still be able to make their mortgage payments if something impacted their cash flows (e.g., income loss, interest rates rise to ‘normal levels’, higher insurance costs, higher condo maintenance expenses).
Why is there a mortgage stress test?
With mortgage rates at record lows, the mortgage stress test requires Canadian borrowers to show their lender that they would still be able to make their payments if faced with interest rates that are roughly 2 percent higher than the current rate.
Since, the government, and taxpayers, will be required to bail out lenders if mortgages default, it is reasonable to protect borrowers from taking on too much debt when rates are at record lows. Particularly because rates are eventually expected to rise to more normal levels in the future.
We said the stress test adds roughly 2 percent to the current rate because it’s actually much more complicated. Most Canadian’s don’t know there are two stress tests. One was implemented by the bank regulator and the other was implemented by the national housing agency with help from the Bank of Canada. Each is calculated differently. To begin with, here is a summary of the key terms you need to understand in order to calculate the stress test for your mortgage application.
Key terminologyPosted 5-year Mortgage Rate: The lender's advertised mortgage rate before any negotiated discounts are applied. Contract 5-year Mortgage Rate: The contract rate is the final negotiated rate that will be used to calculate your mortgage loan interest. Your negotiated 5-year fixed contract rate is often 1 or 2 percent lower than the posted or advertised rate. Variable rate mortgages often don’t have discounts available. Benchmark Qualifying Rate: The rate set by the Bank if Canada and used by lenders to qualify borrowers. This is roughly 2 percent higher than the contract rate. The benchmark rate (five-year conventional mortgage rate) is published weekly by the Bank of Canada and roughly equates to the most common 5-year mortgage rate published by the largest Canadian banks. Calculated Qualifying Rate: Your negotiated contract rate plus 2 percent. Canadian Mortgage and Housing Corporation (CMHC): A fully government-owned agency established after World War II, to help returning war veterans find housing. The CMHC’s responsibilities have since expanded to help all Canadians find a home. CMHC enables easier access to mortgages for home buyers and investors in rental buildings. CMHC is backstopping Office of the Superintendent of Financial Institutions (OSFI): an agency of the Government of Canada reporting to the Minister of Finance created to monitor banks and lenders and ensure that they do not take on too much risk in the pursuit of profits. |
We haven’t gone into the stress test details and already the technical industry jargon above illustrates why the stress test is difficult to explain to the average Canadian. The ideal stress test is easy to explain to anyone.
1. The stress test confusing for Canadians
Earlier, we said the ‘stress test’ ensures Canadians can handle a rise in rates of roughly 2 percent. We weren’t more specific because there are two different stress tests and each is calculated differently:
| Down payment of 20 percent or more | Down payment of less than 20% |
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Once you master the jargon, the various calculations and exceptions make the stress test even more difficult to understand. The complexity makes it more difficult for the average Canadian to make an apples-to-apples comparison between two financing options, and it also consumers more reliant on loan officers and mortgage brokers.
“Every time they make a change, they make it more complicated for the consumer to understand the process and limits their ability to get the best deal for their financing.” – Shawn Stillman, Managing Broker, Mortgage Outlet
Complex financial products disadvantage every Canadian consumer, but lower-income households who are trying to get on the property ladder tend to be at a greater disadvantage. Canadians deserve a simple and transparent stress test to protect them from overextending themselves financially.
Canadians should not need to monitor headlines to see if their home buying budgets will rise or fall because of a benchmark rate change.
2. The stress test causes home price volatility
Canada has experienced an unprecedented level of real estate value volatility. Some of this is due to limited supply and the ascendancy of short-term rental platforms, but there is also a strong and direct correlation between interest rates and home values.
Canadian home prices last peaked in 2016, when mortgage rates were at their lowest. This was followed in 2016-17 by home price corrections in Ontario and B.C. that coincided with rising interest rates.
A working paper by the Bank of International Settlements shows that a 1 percent drop in rates leads to a 6 percent rise in home prices, a rise in rates has the opposite effect.
The current interest rate reductions are intended to help Canadians by lowering their interest charges, but they also increase home buyer budgets. In a market with tight housing supply the lower rates and higher budgets lead to higher prices and, as a result, Canadians borrow more until they are paying as much interest as if rates had never dropped.
Not only is this counterproductive to the policy intentions to reduce the burden of household debt, but it also leads to swings in house prices that have nothing to do with local economic fundamentals. Volatile house prices lead to uncertainty, reduce business investment in new construction, and cause first-time homebuyers to wait on the sidelines.
Ideally, home values linked hand-in-glove to local incomes and local economic fundamentals rather than the volatility of the 5-year bond market.
The effect of falling rates on home buying budgets rises as rates fall further. If we assume a buyer has a household income of $75 thousand and a 20% down payment a qualifying rate drop from:
6% to 5% raises the home buying budget by ~8.8%,
5% to 4% raises the home buying budget by ~9.1%, and
4% to 3% raises the home buying budget by ~9.5%
If Canada switched to a fixed qualifying rate then mortgage rate changes wouldn't cause volatility in home buying budgets (and home prices), they would simply change the homebuyer's monthly interest expense.
3. The stress test is not future proof
Our current test calculated by adding 2 percent to the contract rate doesn’t make much sense when contract rates rise closer to 5 percent because a rate that high is closer to the upper bound that we can reasonably expect and it doesn’t make sense to test borrowers at 7 percent.
This illustrates how the current calculation will become obsolete in the future when interest rates rise, and it will need to be replaced. We may as well replace it today, during a recession, when industry players are more appreciative of the benefit of protecting borrowers from taking on too much risk.
4. The stress test undermines the government’s credibility
The existence of two stress tests creates the impression that CMHC and OSFI are not aligned on which test methodology provides the best outcomes. The appearance of two government agencies disagreeing on mortgage guidelines and creating unnecessary complexity for consumers undermines government credibility. This is of particular concern when the stress tests are supposed to be in consumers’ best interests.
The Solution – A Simple Fixed Stress Test
We recommend CMHC and OSFI adopt a single standard fixed stress test qualification rate rather than the current two stress test qualification rates that can change from week to week. We have referenced a 5 percent qualifying rate for illustrative purposes, but we expect, if the regulators adopt a simple fixed stress test, they will likely choose a qualifying rate somewhere between 4.5 and 5.5 percent.
The stress test is intended to test borrowers against a possible future scenario like a job loss, higher interest rates, higher insurance costs, and higher condo maintenance expenses. The likelihood of these events doesn’t change from week to week and neither should the stress test.
If the stress test benchmark qualification rate were fixed at 5% for both insured and uninsured mortgages this would make for a more credible and easier to explain the test. If rates rise, then the lenders would apply the higher of 5% or the contract rate.
Three key benefits to Canadians
A stress test that everybody can understand.
More stable and predictable home prices.
Future proof - less consumer confusion at a future date when the current calculation becomes irrelevant and needs to be replaced.
OSFI and CMHC are seen collaborating and aligned on a single mortgage qualification guideline
A Likely Objection
Some people may object to a fixed stress test because they believe lower qualifying rates help people 'buy more house', but this is a myth.
An individual buyer can only get 'more house' with a lower qualifying rate if they receive a unique advantage not available to other buyers. Since the stress test is applied to all buyers, no individual buyer has an advantage. Since all participants in a bidding war receive the same budget boost, the same buyer will still win a bidding war.
The winning bidder will buy the same home, at a higher price and with a larger mortgage. They won the bidding war because of higher personal income and savings and not because of lower mortgage rates that were available to all their competitor homebuyers.
Conclusion
If the stress test were fixed at 5% for both insured and uninsured mortgages homebuyer budgets (and home values) would stabilize and more closely align to incomes and the local economic fundamentals of supply and demand.
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