Worst-case scenario planning is factored into so much of our daily lives: We carry umbrellas when it’s cloudy, pop Gravols before taking a long flight, and buy travel insurance when vacationing in other countries. Why should a life-changing decision such as taking on a mortgage be any different?
In finance, planning for a worst-case scenario with an investment is called a stress test. When it comes to mortgages, a stress test is a way of determining exactly how much you can afford and — this is the important part—under what circumstances. For example, if your income was reduced due to a job loss or unforeseen expense, could you still afford to make mortgage payments? What if interest rates spike or you need to refinance your home?
This type of rainy-day planning is important for a few reasons. First, interest rates are on the rise. So, too, are home prices. According to the Canadian Real Estate Association, the national average home price was $496,500 in December 2017 — a year-over-year increase of 5.7%.
Knowing that you can still afford to pay your mortgage in the case of an interest rate increase can make the difference between the type of home you start shopping for or how you re-evaluate your budget if you’re already a homeowner.
Due to new mortgage rules that came into effect Jan. 1, 2018, all homebuyers getting either a high-ratio mortgage (those with a down payment of less than 20% on the purchase price on a home) or an uninsured mortgage (those with a down payment of at least 20%) are now subject to a mortgage stress test and have to qualify at a rate that’s higher than they actually pay. (Previously, only high-ratio mortgages were subject to this test).
Today’s best mortgage rate in Ontario is 2.94% (as of Jan. 18, 2018), but the Bank of Canada’s qualifying rate is currently 5.14%. The stress test is based on qualifying for the greater of either the Bank of Canada qualifying rate or plus two percentage points to the contracted rate.
What that means is that even if you get a mortgage rate of 2.94%, the new stress test requires that you qualify for a mortgage of 5.14% — even though you’ll still be paying the contracted 2.94%.
For most, that will mean qualifying for a home that costs 20% less than they would have prior to the new stress test rule.
So how do you figure out what minimum monthly payment you’re required to be able to afford under the new test? Lucky for you, we’ve got you covered.
Increase the current interest rate
It’s one thing to compare the best mortgage rates on our site today, but you should also assume that mortgage rates could go up in the future. If you have a variable-rate mortgage, which is attached to prime rate, this will immediately affect your mortgage payment. On the other hand, if you have a fixed-rate mortgage, you’ll keep your current low rate for the duration of your term, but will be faced with an increase once your mortgage comes up for renewal.
While it’s impossible to predict exactly where interest rates will be in a few years, an increase of two to three percentage points isn’t out of the question. For example, if you buy a home for $496,500 (the current national average home price), put down 20% and qualify for a five-year fixed-rate mortgage of 2.94%, you’ll have a monthly mortgage payment of $1,868. That doesn’t sound so bad.
But what if mortgage rates increase to 5.14% — the current required stress test rate — after your five-year term ends? According to our mortgage payment calculator, your monthly payment would rise to $2,342. Can you afford that rate today? You will have to be able to – even if you aren’t required to pay that rate – due to the stress test rules.
If not, you may need to weigh your options; do you save a larger down payment and defer the purchase of your home? Do you choose a more affordable home?
Only you know the correct choice. It’s a good idea to speak with your mortgage broker to help you figure out your best course of action.
Below the calculator, we built in an “Interest Rate Risk” section that shows you what the balance of your mortgage will be after this mortgage term, which gives you some examples of what your new monthly mortgage payment can be with a variety of interest rates (based on historical averages). While you probably don’t need to worry about mortgage rates ever hitting double digits again, it’s still good to be informed.
To run multiple scenarios on our mortgage payment calculator, you can also manually enter custom mortgage rates and compare the results to your monthly budget before you buy a home that may be too expensive in the future. If you want to get serious about it, keep a spreadsheet with all the results so you can reference it later.
It also doesn’t hurt to ask a mortgage broker for help when stress testing a mortgage before you buy. In addition to helping you find out what your ideal debt service ratios and maximum interest rate are, they can keep you up to date on changes to lending policies that can affect your mortgage affordability.
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Source: The RateHub