Mortgage Memo: A new income stress test is coming for some borrowers

Memo 1: OSFI to implement new LTI stress test for some borrowers

Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), is planning to toughen up borrowing requirements for some mortgage applicants.

As reported by the Globe and Mail, this latest crop of regulations targets the loan-to-income (LTI) ratios of borrowers, requiring lenders to cap the number of borrowers they have on the books with an LTI over 4.5%. The new rule should be officially implemented in the first quarter of 2025.

The change is part of efforts to limit the number of risky mortgages lenders carry in their portfolios. However, unlike the B-20 mortgage stress test, which is applied to all borrowers taking out new mortgages, this new policy is implemented at the lender level; the limit for the number of mortgages with LTIs over 4.5% will vary depending on the bank, meaning lenders will be able to make exceptions for some borrowers who exceed the ratio. The LTI is calculated by combining all of the loans secured against the property (including HELOCs), and dividing it by the borrowers’ gross income.

The new measures will apply to new mortgage deals only, and do not impact existing loans, or those coming up for renewal. It also will not apply to insured mortgages, where the borrower has taken out mortgage default insurance.

Also read: Insured vs. uninsured mortgages – what’s the difference?

According to OSFI, this new rule will further safeguard the health of lenders’ portfolios, particularly when interest rates are dropping. In other words, they want to avoid a repeat of what happened during the pandemic-era real estate rush, when rock-bottom interest rates – combined with soaring home prices – fueled a surge of borrowers with super-sized mortgages. Those borrowers have since struggled to keep up with their payments as rates sharply increased in 2022 and 2023, with many entering negative amortization – known as hitting their trigger rate – or being forced to sell their homes.

Currently, the number of borrowers who would be impacted by this new measure is fairly small; data from the Bank of Canada shows that the portion of mortgage borrowers with an LTI of 4.5% or more totalled 12% in the last quarter of 2023, which is down from 26% in Q1 2022.

However, as mortgage rates start to drop a larger pool could be affected, as lower rates mean borrowers will qualify for an overall larger mortgage size. Should that larger loan size exceed 4.5 times their income, they may feel the squeeze of this new rule, should their lender choose to restrict them.

We’ll have more to report on what this means for borrowers as this new measure is formally put into practice.

Memo 2: OSFI rejects suggestion to drop stress test for uninsured switches

The Competition Bureau of Canada went to bat this week for borrowers, calling for the mortgage stress test to be dropped for uninsured mortgage holders looking to switch lenders at renewal time.

On March 21, the Bureau released their recommendation, with the intent to improve competition in Canada’s financial sector. Currently, only insured mortgage borrowers avoid being re-stress tested when they change lenders, and only if their original mortgage size and amortization period does not change. Borrowers who remain at their existing bank at renewal generally are not re-subjected to the stress test, unless their financial situation has materially changed.

The stress test requires that mortgage applications prove they can carry their mortgages at a rate 2% higher than the one they actually receive from their lender, with most being tested in the 7 -8% range today.

The practice of stress testing uninsured switches has long been a point of contention within the mortgage industry, with criticism that it is anti-competitive in nature, removing motivation for lenders to offer competitive rates to their existing borrowers, and preventing borrowers from accessing the best rates possible. It also impacts the majority of mortgage holders, as 73% of mortgages were uninsured as of Q2 2023.

“When consumers renew their mortgages, their ability to switch to a competitive mortgage offer is critical to ensure they obtain the best rate and terms to serve their needs,” states the Bureau’s recommendation.

“The benefits for borrowers to shop around and switch mortgage lenders is well known. The expectation to conduct the same stress test again at the time of renewing uninsured mortgages risks harming borrowers and the competitive process. This rule makes it difficult if not impossible for some homeowners to find a new lender and take advantage of cheaper interest rates.”

According to a Bank of Canada paper cited by the Bureau, borrowers who remain with their original bank at renewal pay on average 6.1 basis points more than new borrowers coming to the bank, and 10.2 basis points more than those who choose to switch. However, despite the potential cost savings, only 12.1% of renewing borrowers choose to change borrowers.

However, the Bureau’s demands – which are only recommendations and are not actually enforceable – were struck down immediately by OSFI. In a statement provided to Canadian Mortgage Trends, the regulator says it has “no plans” to adopt the recommendations on the grounds that when uninsured borrowers switch to a new bank, that lender then assumes their risk profile. This is opposed to insured borrowers, who carry coverage against the chance of default, lowering their overall risk profile.

But, as the Bureau points out, allowing borrowers to take out a better mortgage rate can effectively reduce their overall risk profile.

“It is important to emphasize that these borrowers present the same risk in either case, they have the same income and are seeking the same mortgage on the same house,” states the recommendation summary. “In fact, switching, or the credible threat of switching, may actually lower the risk of a borrower’s inability to repay their mortgage to the extent it results in lower interest rates or other more preferential financial terms.”

Memo 3: Stronger-than-expected GDP could make Bank of Canada “less comfortable”

There are a number of data reports that the Bank of Canada heeds closely when making its rate policy decisions; inflation is certainly front and centre, along with labour numbers as well as overall economic growth. That’s why the January Gross Domestic Product (GDP) report out this week, which has surprised on the upside, could throw a wrench into the central bank’s rate cutting trajectory.

The numbers reveal that GDP grew 0.6% in the first month of the year, outstripping the forecasted 0.4%, and marking its strongest month in a year. According to Statistics Canada, the economy was propped up by 0.7% growth in the services-producing industries sector, as well as a 0.2% increase in the goods-producing industries. The end of public sector strikes in Quebec in November and December also drove the uptick in growth. Overall, says the Crown agency, there was broad-based growth recorded in 18 of 20 sectors.

Analysts are already anticipating a strong February, calling for an additional 0.4% gain in the next report. “To put that two-month flurry of growth into perspective, the combined 1.0% gain is as much as the economy grew in the entire 12 months of 2023,” writes Douglas Porter, Chief Economist and Managing Director of Economics at BMO.

“After a prolonged lull through much of last year, when growth was less than 0.1% in total from March to December, the economy looks to have caught some strong tailwinds early this year.”

These surprisingly strong numbers are blowing up original projections for Q1, he adds, saying that should the February estimate come to fruition, even a flat March performance would lead to year-over-year growth of 3.5%. That will exceed BMO’s call for 1.5% in Q1, and the BOC’s own forecast of 0.5%. 

“In turn, full-year growth could be on track for something as high as 1.5%—we were at 1.0%, the BoC 0.8%, and the latest consensus was just 0.7% for the year,” he adds.”

But will a robust Q1 deter the BoC from implementing widely-anticipated rate cuts in the second half of the year?

“The surprisingly healthy start to 2024 points to above-potential growth in Q1, which could make the BoC a bit less comfortable with the inflation outlook,” says Porter. “Our call for a June rate cut still hinges on the coming CPI reports, but if this strength in activity is close to replicated into Q2, the BoC will see much less urgency to cut rates any time soon.”

Also read:

• Mortgage payment defaults are on the rise
• Bank of Canada holds target interest rate at 5% in March 2024 announcement
• February Canadian CPI falls to 2.8%
• Rising home prices eroded affordability in February