Borrowing costs have fallen drastically in recent months. That has further widened the gap between the best-discounted mortgage rates and the government's “stress test” rate, which new borrowers must prove they can afford.
That gap is particularly eye-opening when you look at the lowest rate in Canada, currently a one-year fixed rate of 1.59%.
By comparison, today’s minimum stress test rate seems excessively high, a whopping 3.35 percentage points higher.
The gap is wide for two reasons:
1) Regulators decided that the minimum stress test rate must equal the typical big-banks' posted 5-year fixed rate. The Bank of Canada tracks that rate and it’s currently 4.94%.
2) Big banks are unwilling to lower their posted 5-year fixed rates, despite plunging market rates.
The original point of the mortgage stress test was to ensure borrowers can handle theoretical interest rate increases during their term. That way, lenders could be more confident that they'll continue to make their payments.
But now, the stress test no longer honours its stated purpose. For example, not a single mainstream economist projects interest rates jumping anywhere near three percentage points in the next five years, let alone next year.
That raises a legitimate question…is the mortgage stress test broken?
“We definitely want people to be qualified. But the current benchmark doesn’t make sense,” Jerome Trail, owner and broker of record at The Mortgage Trail told Toronto Storeys recently. “The test should be in line with what’s actually happening in the industry.”
And currently, the industry is seeing record-low rates that are far below the qualifying rate. Most terms now boast rates below 2.00%, including the ever-popular 5-year fixed.
Now, consider the 1.59% one-year fixed rate. The average borrower with this rate would see a full two-thirds of their monthly payments going towards principal repayment, with the remaining third being interest. That's dramatically less interest than almost anytime in the past.
Compare that to the days of 2.99%, last decade’s much-celebrated benchmark for a “historically low” rate. Back then, borrowers saw just 48% of their payment go towards their principal.
There’s an overarching economic benefit to encourage qualified customers to borrow at such extremely favourable rates, particularly in a recession like we now find ourselves. By contrast, many would argue that making a prudent, reasonable borrower prove they can afford a rate they’ll never experience is not only arbitrary, but economically and socially detrimental.
It’s not like government officials are oblivious that the current qualification rate is out of whack.
Back in February, the Department of Finance announced plans to change the stress test rate used for borrowers with insured mortgages (including those who make less than a 20% down payment).
But in March, the government put those plans on hold, citing the COVID-induced economic crisis.
The government’s proposed new stress test rate was changed to equal to the weekly median 5-year fixed insured mortgage rate, plus 2%. When it was announced, the new qualification rate would have been 4.89%, 0.30 percentage points less than the stress test rate at the time.
Fast forward to today. Had regulators fixed the stress test as planned, borrowers would now be qualifying at 4.39%, 0.55 percentage points less than the current 4.94% benchmark.
In other words, today's borrowers are being made to qualify at rates that are even further detached from reality.
Calls have been made for officials to speed up deployment of their stress test tweaks. But so far, proponents are hearing crickets.
“Continuing to pause the previously announced changes leaves in place an unnecessarily punitive, pro-cyclical and suppressive minimum qualification rate that is more than double the expected interest rate most borrowers would pay,” Mortgage Professionals Canada President and CEO Paul Taylor told RateSpy.com last month.
“To help minimize the expected [home] value reductions and erosion of millions of Canadians’ net worth, the announced change should be implemented before the mortgage deferral programs expire [this fall].”