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Canada’s Mortgage Stress Test: Intended and Unintended Effects

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Canada’s Mortgage Stress Test: Intended and Unintended Effects
3 min. read

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Canada’s largest cities have continued to see declining housing sales and prices since the mortgage stress test was introduced in 2018. But is this an intended effect or merely a coincidence?

Mortgage Stress Test Recap

The mortgage stress test requires that borrowers be able to qualify for an interest rate that is 200 basis points higher than the actual contracted rate. This is meant to ensure that borrowers could still pay their mortgage, even if rates were to rise, by avoiding offering mortgages that are significantly more than a borrower’s economic situation can handle.

As a backdrop, a 2018 survey of homeowners conducted by the Bank of Montreal revealed that 83% of Canadians have debt, 76% of which comes exclusively from their mortgages.

Intention of Stress Test Clarified

Many believe that the mortgage stress test was set up specifically to lower home prices in Canada. However, the Office of the Superintendent of Financial Institutions Canada (OSFI), which is the regulator that put the stress test in place, says that was not the intention.

Carolyn Rogers, the Assistant Superintendent at OSFI, stated in a recent speech to the Economic Club of Canada, that the stress test was simply “designed to target mortgage underwriting standards” and provide a sort of buffer so that borrowers do not “stretch their borrowing capacity to its maximum.”

Reduction in High-Risk Lending

The intended result of the mortgage stress test seems to have been achieved so far. A Bank of Canada report revealed that it has decreased high-risk lending across the country and that while the quantity of credit being offered has decreased, the quality of credit provided has improved.

In 2016, the first phase of the stress test targeted high-ratio mortgages (loan-to-value ratios exceeding 80%), and in particular borrowers who had loans that were more than 4.5 times their annual income. While this helped to reduce the number of new high-ratio mortgages offered, it didn’t do as much to lower the total number of high-ratio mortgages extended to borrowers with high debt.

Two years later, in 2018, the stress test was expanded to include low-ratio mortgages (loan-to-value ratios under 80%), which ultimately did the trick.

Effects on Real Estate Markets

Those who back the stress test say it is working as it was meant to, and they believe it has also played a part in making housing more affordable.

Since the mortgage stress test was first introduced in January 2018, housing markets have noticeably weakened. For example, in the Toronto real estate market, housing sales last month were 2.4% lower than they were last February. Even in February 2018, sales had already decreased by 35% compared with the numbers from February 2017.

In the Vancouver real estate market, the decline in sales last month was even steeper, at 33% lower than February 2018. And February 2019 sales stats in Vancouver are 43% lower than the city’s 10-year average.

When it comes to housing prices, a quality-controlled index shows that prices in Vancouver for February were down 6% year-over-year. In Toronto, they were up slightly by 2.4%.

Other Possible Effects

Aside from weakening home sales and decreasing home prices in most Canadian cities, the mortgage stress test may have other unintended consequences, such as pushing borrowers who don’t qualify for a mortgage due to new regulations to seek financing elsewhere.

In particular, there is concern that unqualified borrowers will look to lenders that are not regulated by OSFI and that these unregulated lenders may charge them significantly higher interest rates. Only federally regulated lenders are required to enforce the stress test. Those governed by provincial authorities or other bodies are not.

While having a “margin of safety” in place when there are low-interest rates and high consumer debt levels is important, economic conditions constantly fluctuate and policies such as the mortgage stress test will likely need to be continually reviewed and adapted to market conditions to properly protect borrowers and reduce any negative effects on housing markets.

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