New stress test for home buyers
Since January 1, 2018, new home buyers, including those making a 20% or larger down payment, need to prove they can afford higher payments if interest rates rise. Mortgages will only be approved for home buyers who can afford payments based on the greater of:
- the financial institution’s contract mortgage rates plus 2 percentage points;
- the Bank of Canada’s posted 5-year benchmark rate.
Actual payments are not impacted, but the higher threshold will make it harder to qualify for bigger mortgages. For those not passing the test:
- Consider buying a cheaper home.
- Postpone buying until you qualify; with higher income or larger down payment.
- Find a co-signer with sufficient income to help you to qualify.
How much can you afford? You must answer this question before buying a home. Whether considering CMHC insurance or not, you should always consider the size of your mortgage, which can have a greater impact on monthly payments or cash flow than CMHC insurance, interest rates or the amortization period combined.
Traditionally, banks calculate a person's total debt service (TDS) ratio and gross debt service (GDS) ratio to see how much of a person's income goes toward servicing their debt.
These ratios determine how much the bank will lend:
Note that the CMHC would usually restrict TDS and GDS to 42% and 35% respectively.
Often, banks will calculate the largest mortgage a person can afford to carry and offer to lend that amount. However, the banks don’t always take into account that a portion of monthly income is needed to pay for childcare or to save for a child's education or retirement. Many people find themselves borrowing as much as the banks will lend, which leaves little left over for other financial goals when mortgage payments are due.
Many people are pre-approved for mortgages. The bank calculates how much they will lend you before you start looking for a house. Pre-approval can make house shopping easier, as there is already a maximum price level set. However, it doesn't mean you should spend the entire amount.
The bank's limit will be the maximum, but the final price range you choose should be based on your own budget and comfort level. In addition, consider the impact higher interest rates, reduced income due to illness, job loss, the birth of a child or unpredicted home repairs could have on your ability to meet mortgage payments. Remember, one of the factors of financial success is living below, not above, your means.
Once you’ve decided how much house you can comfortably afford, it’s time to consider the details of the mortgage. While the single largest factor in your monthly payments and overall interest cost will be the size of your mortgage, there are other factors that should be considered such as mortgage terms and renewals, additional payments and payment frequency.