Stress Test: A Change in Credit Approval

In the last few months, we have been hearing a lot of talk about the recent bank measures whose final phases were put into effect at the beginning of 2018. Expressions such as “B20” or “stress test” certainly did not leave us indifferent, since every media outlet has been talking about them. How important are these changes, and what we can expect after they are put into place, is the theme of this article.

First of us, let us explain some of these commonly used terms that are flooding the media in the last few months:

B20 is a series of measures established by the OSFI (Office of the Superintendent of Financial Institutions, the main and independent regulator of banks in Canada) whose intention it is to stabilize the economic situations in the country by controlling the way in which mortgages are approved. In other words, it is a series of rules and procedures tied to approving credit of real estate, whose goal it is to “make it harder” to approve credit, all with the intention of making sure that the process does not get out of control.

B20 is a process that was established in phases, starting a few years ago, bringing in partial changes up until it reached its peak on January 1^st, 2018, when the final measure came into effect. That last phase, in a way, can be described as a final “stress test” for everyone, regardless of down payment.

What is this stress test?

Until recently, if you applied for a mortgage, and if you had a down payment of 20% or more, banks used the interest rate that you received on the commitment (for example, 2.99%) and an amortization of 30 years as the components that would establish the maximum loan that you could qualify for. Let us say, if you earned $100,000 a year, your earnings allowed for you to get a mortgage of approximately $500,000.

Starting on January 1^st, 2018, regardless of down payment, banks have to use a maximum of a 25-year amortization and the commitment interest rate plus 2% (so, in our example, 2.99% + 2% = 4.99%) in order to calculate your maximum mortgage amount. To clarify, they use the commitment interest rate plus 2% or the posted Bank of Canada rate—whichever interest rate is higher—but I believe that you understand that this interest rate is significantly higher than the one you get on the commitment.

From a practical point of view, your purchase power falls by around 20%, if not more. What was once $500,000 that you could qualify for is now $400,000.

This harder, stricter, and let us say rigorous method of approving credit is in fact this so-called stress test, more precisely, its final phase.

Just to be clear, the stress test does not affect the interest rate you receive. You still receive the same interest rate of 2.99%, for example, and you will still receive an amortization period of 30 years, but the way in which you are approved for your maximum amount is now much stricter.

It is important to mention that the levels of the stress test have been changing over the last couple of years. A starting version existed for all clients whose down payment was less than 20%. Later, this was established for all variable rates and fixed rates with terms less than five years. This final phase is the one that will stay with us and is the only important one at this moment.

Let us get back to the reasons. Why the measures? What was going so badly that they had to bring in all these changes?

First of all, interest rates…

In the last 10 years, we were lucky to be able to borrow money at very affordable rates. Many would say, and absolutely correctly at that, that they were unrealistically low rates. The reason was the global financial crisis that required the central banks to keep their interest rates low in order to stimulate spending, and through that, to influence economic growth. It is a well-known fact that if interest rates are low, money is cheap, and therefore it should be spent. If interest rates start going up, then it pays off more to save and that is how it goes—the standard way that central banks control their respective markets.

However, at the rate things were going the last few years, there were signs that we would soon be leaving that drawn-out financial crisis behind, and that according to that cycle, interest rates would soon start going up. This was all worrisome to the government because of the large number of people who bought up real estate and were paying very low interest rates. Would these same people that were paying 2.5% be able to afford these same properties if the rates are twice as high? If not, what will happen to these mortgages and respective properties?

Since there was no way to influence individuals who already had mortgages, the government established a stress test in order to control all future buyers, and in general, all future credit candidates. The only way to avoid the stress test would be in the case of simply renewing an existing mortgage once the term came to an end—that is, you were not borrowing any additional money. But as soon as you decide to refinance, even in the case of a minimal addition, you will have to go through the stress test.

Initially, the stress test was brought in for those potential candidates that would be most affected by a higher interest rate—buyers with minimal down payment. The reason was fairly clear—if interest rates went up and if these people could not pay their mortgages, it would be easiest for them to close their doors and hand their keys over to the bank, since they have the least to lose (the process of handing keys back to banks in Canada is far from easy).

The stress test was also established for those who requested variable mortgages or for terms shorter than five years, since any abrupt change in the variable rate could have an immediate or relatively quick influence on the growth of interest rates.

Finally, at the beginning of 2018, the stress test was applied to everyone else, regardless of mortgage type or down payment. It was brought in to protect us from ourselves, from our comfortable low interest rates. It was brought in for us to be sure that we could afford what we buy and pay off what we borrow, in case interest rates were to rise to the level they should generally be at.

The other reason is the abrupt rise in real estate prices, especially in metropolises such as Vancouver and Toronto

It is well-known that the government was seriously afraid that real estate prices in these cities were starting to grow too quickly and that, if this trend were to continue, a large number of people would soon be unable to afford a roof over their heads—at least not a roof that you own, in other words.

Because of this, from the point of view of supply and demand, it would be logical that if mortgage approval conditions were to become stricter, a good number of potential buyers would fall out of the game, demand would fall, and this would influence a formulaic fall in real estate values. In this way, the stress test would contribute to falling prices and some sort of stabilization.

What can we expect with these changes, and how will all this affect real estate prices?

As always happens with big changes, I think we can expect a short lull before things get back to normal.

The reason for this is the fact that a large number of candidates, those who were most affected by the new rules, hurried to buy or refinance before the end of 2017. An unusually large number of mortgage requests before the end of the year was proof of this. Those candidates who did not manage or simply did not want to hurry and deal with things under stress will probably allow things to settle, and see whether there will be any big changes on the market before continuing on.

The number of (until recently) potential candidates will, unfortunately, simply have to forget about the possibility of buying, at least for a while. Seeing as their purchasing power has fallen by about 20%, many will have to wait for better income, more savings, or change their strategies about what or where to buy. This is mostly the case with millenials, a good number of whom are known for wanting to live downtown and that buying outside of Toronto is simply not an option for them. These tendencies indicate that a large number of precisely these people will look for an alternative in renting, and therefore rental prices will go up.

A portion of potential buyers will simply have to adapt to their surroundings—that is, to find an alternative means of realizing their goal of being homeowners. Some will go to the “bank of mom and dad,” in other words, use the equity that was created on the family home (or even rentals) thanks to the excellent strategies of the parents to buy real estate in the right place at the right time. For some, their parents will even act as guarantors.

One portion of candidates—whether they are potential buyers or those who have to refinance, and who are not able to get help from anyone else— can always research and use alternative lenders such as “B” lenders and private loans, where it makes financial sense.

After the aforementioned lull, where the price of real estate might fall a bit, I believe that we should expect a period of stable prices with some minimal growth. I believe that Toronto as a city has the potential of further growth, and that the constant influx of immigrants is a very significant factor that contributes to that—as long as there are jobs.

I personally think that these changes are not bad. What is more, I believe that a stable market is the best market, and that these new regulations contribute to that stabilization. I am not even too concerned about how much these changes will affect us. We will figure it all out somehow, which we have always done well until now. We have been through much worse…

* The calculations used in this article are only illustrative. Exact calculations are dependent on many factors.