The financial well-being of Federally Regulated Financial Institutions (FRFIs), like Canadian banks and Canadian insurance companies, is essential for the stability and health of the Canadian economy. Thus FRFIs are expected to ensure their mortgage borrowers can absorb some adverse shocks. A negative shock can come in the form of a higher mortgage rate, reduced income or an unexpected increase in expenses.
An FRFI performs a mortgage stress test before agreeing to a mortgage to ensure the borrower's ability to absorb a shock. A mortgage stress test assumes that your mortgage rate rises to the mortgage qualifying rate (MQR). One passes the stress test if their mortgage is still affordable at the MQR.
The mortgage qualifying rate (MQR) is the greater of a floor of 5.25% or your mortgage contract rate + a buffer of 2%. MQR is set by the Office of the Superintendent of Financial Institutions (OSFI) for uninsured mortgages. At the same time, MQR is set by the Department of Finance (DoF) for insured mortgages. Currently, both OSFI and the DoF have developed the same MQR. This rate came into effect on June 1, 2021, and was reaffirmed in December 2021 and December 2022. Before June 1, 2021, the floor for MQR was 4.79%.
OSFI has a framework to review both the floor and the buffer of the MQR regularly. Such a review can occur at any time but would occur at least once a year in December. The finance minister often makes an announcement about MQR hours after a similar announcement by OSFI.
Note that only Federally Regulated Financial Institutions (FRFIs) are mandated to perform a stress test. The stress test is put in place to guarantee the stability of Canada’s financial system. Yet it is a good thing for borrowers as well. A borrower who borrows less than what they can afford to borrow will be able to absorb a negative shock without having to go through painful or traumatic adjustments like an eviction.
Still, if you understand the risks involved and the only thing standing between you and your future home is a stress test, you can use a provincially regulated financial institution. For example, credit unions are provincially regulated, so they do not have to perform a stress test.
In Canada, OSFI regulates banks, insurance companies, trust companies, loan companies and pension plans. OSFI is an independent federal agency which reports to the Minister of Finance. OSFI is mandated to protect depositors, policyholders, financial institution creditors, and pension plan members while allowing financial institutions to compete and take reasonable risks. Canada Deposit Insurance Corporation (CDIC) and the Bank of Canada (BoC) are other regulators of financial institutions in Canada.
The “Financial Institutions and Deposit Insurance Amendment Act" and the “Office of the Superintendent of Financial Institutions Act” were enacted in 1987. As a result, the “Department of Insurance” and the “Office of the Inspector General of Banks” were combined, and the Office of the Superintendent of Financial Institutions (OSFI) was created. Since then, OSFI has supervised and regulated all federally regulated financial institutions.
In 1996, bill C-15 became law. Bill C-15 clarifies OSFI’s prime role in minimizing losses to depositors, policyholders and pension plan members. OSFI is also tasked with maintaining public confidence in the Canadian financial system.
Residential mortgages are the largest exposure for many Canadian financial institutions. As a result, OSFI pays special attention to regulating mortgages. Regulation of the mortgage industry became considerably more stringent after the 2008 financial crisis when the American mortgage industry almost destroyed the global financial system.
OSFI expects financial institutions to judge the borrower's ability to pay their loan over the amortization period before granting a mortgage. OSFI has issued guideline B-20, which outlines the standards to be followed when approving mortgages. This guideline governs the underwriting of any loan secured by residential property. Residential property is a dwelling (any type of home) with one to four units. So, in addition to mortgages, it regulates HELOCs and equity loans.
B-20 asks lenders to act based on five principles.
Let us consider the purchase of an average home in Canada with a price of $630k. Let us further assume that the purchaser has saved $100k for their down payment. Further, assume that they are interested in a five-year fixed-rate mortgage and that they can get a rate of 4.6% for a mortgage with a 25-year amortization period.
Using a mortgage payment calculator, we note that their monthly payment would be $3,046. Assuming they have little debt obligation, we only consider their gross debt service (GDS) ratio. In order to consider your mortgage affordable, your GDS should be at most 39%. Meaning that you would need a gross monthly income of $3,046/0.39 = 7,810 to afford this house.
Now let us consider the stress test. The stress test requires us to consider a 2% safety margin. Meaning that our purchaser needs to afford his mortgage at an interest rate of 6.6%. Going back to our mortgage calculator and changing the interest rate from 4.6% to 6.6%, monthly mortgage installments increase to $3,683. For this installment to be affordable, you need a growth monthly income of $9,444.
As you can see, in the absence of a stress test, a family earning $7,800 a month could afford the average Canadian home. In the presence of the stress test, that same home is only affordable for families earning more than $9,400 each month. Thus stress test is there to have people choose more affordable houses and reduce the risk that they might default in the future.