Does the Mortgage Stress Test Still Make Sense... And Has it Ever?

More than half a decade of the mortgage stress test on Canada’s housing market -- first introduced in 2016 and expanded in 2018 -- has seen a pandemic buying frenzy, surging inflation, rapidly rising interest rates, and a major pricing slide.

So, has it kept Canadians in a safety bubble as intended? And what does its future look like?

The Ontario Real Estate Association (OREA) never liked the stress test. The association was among industry players critical of the measure, agreeing with the intent but not the bluntness of the instrument.

READ: 80,000 Mortgage Borrowers to Hit “Trigger Point” as BoC Keeps Hiking Rates

“We thought it was a straitjacket, one-size-fits-all approach,” says CEO Tim Hudak. “Mortgage and housing clients will vary in their risk, whether you’re in a big city, a higher-end of the market, a lower-end, in a small town or in another province, right? So we suggested more flexibility. When it came to the stress test, we did not believe it should be there for refinancing. And there are also some bizarre, unintended consequences on entrepreneurs and small business owners that needed to be fixed.”

The stress test had some merit in 2016 with rates at historic lows for so long, says Ken Fadel, principal broker at Crescent Mortgage Corp. -- raising a whole generation of young Canadians who had never known moderate interest in their lives. He agrees that, as intended, it removed some froth from the market.

But he believes its wider effects were lost in other changing market variables. The Canada Mortgage and Housing Corporation (CMHC) defended the tests in 2019, but a pandemic buying spree nevertheless followed. 

“I’ve never seen anything to clearly state the impact of those of the stress tests,” Fadel says. “I don’t think it’s done a whole heck of a lot to be honest with you. I mean, the drop in high real estate prices -- what they were concerned about -- it did nothing for that. If anything, the only thing that has dropped [prices] has been the rate increases, not the stress test. That, combined with inflation, people just are obviously paying more for everything right now. I’d be hard pressed to sit here and tell you that the stress test has been an overwhelming success.”

‘Water Finds Ways Around Rocks'

Scott Terrio is far removed from the homebuying industry -- as manager of consumer insolvency for Hoyes, Michalos Licensed Insolvency Trustees, he’s a frequent media commentator on Canadians and their debt. People see him when their finances are falling apart.

Terrio agreed with the stress test and in fact thought it should be more strenuous. But he doesn't think it necessarily solved a whole lot either -- believing we had already painted ourselves into a corner with cheap money for so long, as well as the measure not accounting for inflation. 

Homeowners have recently been coming to the firm, Terrio says, which would have been unheard of a couple years ago. Owners are typically a tiny fraction of filings because they have more borrowing power than renters, but when they show up, they actually come with more unsecured debt.

“Everybody lives monthly,” Terrio says. “That’s why people come in to see us. They don’t come in to see us because they owe $400,000 in a mortgage and $100,000 in credit card debt -- they come in because they can’t handle their monthly [payments] anymore. That’s it.”

Stress-tested homeowners should have a buffer but he still hears a lot of hysteria around the rate increases, suggesting a few possibilities to him: Canadians had a sense of entitlement around free money for too long; homeownership was viewed as a get-rich-quick scheme but now price drops have all but wiped out equity for the most recent buyers; people underestimated the costs of actually carrying a property; or buyers felt invincible and didn’t rein in spending. Or, potentially, passing their stress test was dubious.

“When you have a situation like [the stress test], things will go funny, right?” Terrio says. “I heard a lot of stuff from brokers and agents about the shenanigans that were going on. The inherent nature is that people will find ways -- like water finds ways around rocks.”

‘Unintended Consequences Outweigh Any Potential Benefit'

In terms of 'water around rocks,' the stress test drove desperate buyers into riskier places. 

Fadel points to the “absolutely crazy” pandemic market, sending borrowers to variable rates under the stress test because they qualified for up to 20% more -- but now these buyers are already struggling under "skyrocketing" increases. And others found money in more expensive places.

“The stress test did nothing to stop that because even if you didn’t go to an A lender, there’s credit unions who aren’t subject to those rules, there’s private lenders, alternative lenders, that people turn to anyways -- and they made the same decisions anyway,” Fadel says. “If anything, the stress test pushed more people to those fringe lenders, and you’re seeing people paying a lot more money.”

“I think the unintended consequences outweigh any potential benefit,” he adds.

‘Don’t Count on Repayments'

The final verdict on stress tests will trickle in over the next few years as mortgages are getting renewed, says Jason Heath, managing director at Objective Financial Partners Inc., a fee-only financial planning firm. Heath supported the stress tests and believes the pandemic mania would have been worse without them.

Heath’s clientele is not quite the “average Canadian” -- the individuals and families he works with are typically higher net worth. He has worked with some younger, accomplished professionals that still struggle to buy in a market like Toronto, but the stress-test issues he handles are usually around second properties and parental gifts.

“I have lots of clients who are helping out their children by 'loaning-slash-gifting' them money to be able to qualify,” Heath says. “Oftentimes the bank will make parents sign a gift letter to document that it’s a gift with no strings attached and no repayments. And I always tell parents who are making those gifts or loans to their kids: If the bank won’t approve your child to buy this home, it probably is beyond their reach. So don’t count on repayments.”

‘Level the Playing Field’

If you were wealthy, already owned a property, had wealthy parents and co-signers, received large cash gifts -- the stress test was probably stress-free.

So who was affected? First-time buyers, younger buyers, newcomers, middling- to lower-income families. Letting too many of these buyers into a hot market at low rates threatened the Canadian economy, according to the CMHC's reasoning.

But homeownership is also how Canadians build longterm wealth and financial security, OREA and other groups pointed out. The housing market increasingly became a highway for the rich to get richer, as aspiring buyers on the lower-end of the market had a new roadblock.

“Anybody coming from a modest background -- they’re a renter, they don’t come from a wealthy family -- they really had one hand tied behind their back,” Hudak says. “And that’s not fair. If we want to give better access to those who aspire to join the middle class, the stress test needs to be fixed … And we should bring back the 30-year amortizations.”

Lengthen the amortization, lower the monthly payments, and refinance later -- the 30-year mortgage is a “common tool,” Hudak says, for millennials and first-time buyers. Younger people will likely earn higher incomes and accrue savings as they progress in their careers. 

“If we truly want to level the playing field for those who aspire to join the middle class -- hard-working, saving every penny, but they can’t rely on a wealthy family -- they should have the option of a 30-year mortgage amortization,” he says.

‘This Is The Time To Adjust It’

And what now? Interest rates are up, prices are down, the stress test is higher than ever. The Bank of England just dropped their equivalent of the stress test, Fadel points out, relying on a loan-to-income measure to qualify buyers instead. 

Industry players are questioning the relevancy of the test without any new direction from the Department of Finance and the Office of the Superintendent of Financial Institutions -- only that they’re watching the market. 

But both Hudak and Fadel say changes are overdue -- Hudak calls it a “tightening noose” in the current rate environment.

“I don’t know what else they’re looking for to be completely honest,” Fadel says. “I’m guessing they’re going to wait for the Bank of Canada announcement in September. I would be shocked if there wasn’t [a change to the stress test] this year … And if we start seeing the inflation numbers continue to flatline a bit and start to drop, I think you’ll start to see we’re at the top of the interest rate cycle. And I have to believe that once they’ve determined that, this is the time to adjust it.”