Tougher Canadian Mortgage Stress Test Rules From OSFI 2023 & What This Means For Toronto Real Estate
Introduction
Mortgage stress tests aren’t doing as much these days to prevent worst-case scenarios for the Canadian banking system. Last year at this time, mortgages were still stress tested at 5.25%. But as you probably know, variable mortgages are well over that now and might get even higher.
Because of this, OSFI is now trying to toughen up regulations. In fact, this month, they released a list of potential changes to tighten bank lending likely by Q3 of this year. So what might happen, and more importantly, what might this mean for Toronto real estate? Keep watching, because I’ll be talking about it right after this.
Mortgage Changes Over Time
Let’s look at how mortgage approvals have changed over time. The B-20 mortgage stress test guidelines that we’re using right now were first created in 2012, and back then, stress tests only applied to those putting less than 20% down. Toronto real estate was on another steep trajectory up in 2017 and then crashed, and from that point, OSFI decided that lending rules need to be stricter.
So in 2018, stress tests started being applied to all mortgages. This stress test rate was 5.19% in 2019, then dropped to 4.79% in 2020 and then went back up to 5.25% in 2021. Now it works is that all existing debt is calculated as at actual rates, and the new mortgage is stress tested with a higher interest rate.
But even with the higher stress test rate, prices continue to balloon throughout COVID and now OSFI is actually going to be making more drastic changes to change lending rules. Right now, they’ve suggested proposed changes and are opening up the stage for feedback until April 14. Then, based on feedback, they’ll be implementing some of those proposed changes, probably closer to Q3 of this year.
Interest Rate Risk & Possible Changes
Now the biggest risk for banks is definitely rising interest rates. The risk is elevated for variable mortgages, non mortgage loans, and also shorter-term mortgages. Take a look at this. Those who got an $800,000 variable mortgage with a trigger rate starting at 1.75% were paying $2,855 per month. Nowadays, they’re paying $3,739 a month, so that’s a 30% increase.
But this increase is actually lessened because there was a principal paydown and trigger rate buffer. For other types of variable mortgages and HELOCs, the increase is actually even more. Then, there’s the renewal risk that applies to all mortgages, and but higher risk for shorter-term mortgages. Basically, if someone locked in a short 2.5% interest rate for one year and then suddenly rates spike to 5.5%, that ends up being a huge 43% spike in monthly payments.
The first thing OSFI plans on doing is to make major changes to the way the stress test is done. For example, they might consider putting in tougher tests for variable mortgages, shorter-term mortgages, or non-mortgage debt like HELOCs. They might also look into making it harder for people to borrow bigger amounts of money like putting in tiered stress tests, capping the amortization to increase mortgage payments of existing debt used for stress test calculations, using higher rates instead of actual rates to calculate existing debt payments, or possibly asking for a bigger downpayment percentage for those who have more debt.
Outstanding Loan Risk & Possible Changes
Now one big risk is the impact of rising rates, but another, bigger risk is the effects of too much leverage in rising interest rate situations. Basically, with the current stress tests, borrowers are able to rack up a lot more loans when interest rates are low and their debt-to-income ratios look better.
When that happens, they’ll be at a higher risk of non-payment and defaults when rates rise which is another big problem. So, if OSFI thinks that this is a big issue that needs to be addressed, we might end up seeing a new stress test that looks at total loan to income on top of debt to income.
What This Means For Toronto Real Estate
And if we think about where all of this is going, you’ll start to realize that most of these changes are going to make it harder more so for those with existing debt to borrow more money. And that just means it’s going to get harder for real estate investors to scale in the future.
In the short term, once more people start to digest these potential changes and once we get more clarity from inflation, GDP, jobs data, and where interest rates are going, this might actually cause investors to push forward their purchases to Q2 to be able to qualify before stricter lending kicks into effect. This might end up aligning with the time we expect more over-stretched home owners to have to sell, and so both of these factors might mean a pick up in real estate activity probably in Q2.
But in the long run, this will slow down the pace of growth from investors, and end users with no debt will be the ones with a huge buying advantage. Demand and higher growth will funnel to the starter home markets, and the investment markets that overlap more with these types of homes will benefit.
And so if investors want to scale and grow their real estate portfolios, they will have to be a lot more strategic moving forward. Buying condos wouldn’t be a good idea if they’re looking to scale more because the much lower rent yields will cap their future buying power pretty quickly.
What would make a lot more sense is to choose a multi-unit home with better cash flows And then doing things like adding more units or adding an extra laneway suite or garden suits would be the ideal recipe to improve stress test ratios, which ends up making it faster to scale and grow.
Now as we know at least one or more of these changes are likely going to happen, it’s pretty important to plan out your roadmap if you’re thinking about investing and scaling in the long run. And so, if you’re looking to buy this year, looking to scale in Toronto in the long run, and want to talk to a real estate investing expert about what you to do, let’s chat.
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