Now that interest rates have surged to their highest levels in more than a decade, the odds of a further spike in the period ahead have greatly diminished. This will (or should) be an important consideration when Ottawa decides on potential adjustments to the mortgage stress test’s minimum qualifying rate (MQR) on December 15. Whether there will be any changes made to the size of the MQR’s hefty buffer is another matter. We suspect policymakers will want to maintain a high degree of stringency in order to contain borrower or systemic risks in still highly uncertain times. Getting rid of the stress test altogether wouldn’t be advisable, nor is it even under consideration. The test is an important prudential policy tool that is proving its worth in the face of soaring rates.
Stress test is a hot-button issue
The mortgage stress test has been a source of tension from the moment Ottawa rolled it out in its current form in 2018. Federallyregulated lenders must ensure borrowers are able to withstand a sharp increase in interest rates by using a markedly inflated qualifying rate (the highest of 5.25% or the contract rate plus 2 percentage points). This rate has frustrated potential home buyers with less than stellar borrowing credentials—some of whom are no longer able to get a mortgage from federally-regulated lenders (at least temporarily). It’s also impacted stronger borrowers by reducing the maximum size of mortgage they qualify for.
The test fulfilled its main purpose: protecting against a rate shock
When interest rates were at historic lows, it made perfect sense to test borrowers against a massive increase. Indeed, the low rates meant there was a high probability of an increase over the term of the mortgage (five years is the most common in Canada). The events of the past year are a case in point. The Bank of Canada’s policy rate increase has been sudden and massive (up 350 basis points in just eight months). The subsequent shock now confronting borrowers is exactly what the test was designed to protect against. It has enhanced both their resilience and that of Canada’s financial system.
Is what was optimal a year ago still the case now?
But today’s rates are much higher. The likelihood they will rise by another 200 basis points is slim. Since the Bank of Canada adopted its inflation targeting policy in 1991, the 5-year fixed mortgage rate has been above the current qualifying rate (around 7.7%) only 16% of the time. By comparison, when the stress test was implemented in January 2018, the qualifying rate at the time (around 5.3%) had been exceeded 50% of the time in the prior quarter of a century. Clearly the stringency of the test has significantly increased. Has it become overly stringent in the current (and foreseeable) circumstances?
The stress test isn’t just about interest rates, though. It’s also intended to guard against other potential shocks like a drop in borrower’s income (e.g. due to a job loss) or developments (e.g. soaring cost of living, recession) that could threaten one’s ability to service a mortgage. As we contend with four decade-high inflation and with our economy teetering on the brink of recession, such risks are evidently elevated.
Policymakers poised to err on the side of caution
So while there is a valid case to reduce the MQR buffer, we think Ottawa policymakers are more likely to err on the side of caution and leave the large 2 percentage-point buffer in place. We also suspect they would beleery of any moves that might ultimately stimulate housing demand at this stage—or go against the Bank of Canada’s efforts to cool our economy down to tame inflation.
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Robert Hogue is responsible for providing analysis and forecasts on the Canadian housing market and provincial economies. Robert holds a Master’s degree in economics from Queen’s University and a Bachelor’s degree from Université de Montréal. He joined RBC in 2008.
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