So why is this? It’s all to do with the “Stress Test” and how when you’re qualifying for a mortgage it’s not based on your “Contract Rate” (the rate your payment is based on), but on the following:
“Either the Mortgage Qualifying Rate” (MQR) or the Contract Rate Plus 2%, whichever is greater”.
The stress test was originally introduced by the federal government as a margin of safety to ensure borrowers would still be able to make their payments should rates rapidly increase, of if they faced a change in circumstances.
As the MQR is 5.25%, once rates go above 3.25%, which for a lot of lenders their fixed rates already have, we’re therefore “stress testing” your mortgage at the contract rate plus 2%. Eg. your rate is 3.49%, so we’re qualifying the mortgage at 5.49% and not 5.25%. This in turn decrease what you qualify for and therefore your purchase power.
If fixed rates continue to increase at the pace they are, mortgage affordability will continue to decrease in turn, but perhaps the upside could be that price reductions in over-heated markets will occur.
Consider the following: Your household income is $110,000. Using the MQR of 5.25%, you qualify today for a mortgage of roughly $544,000 for a condo costing $680,000, with typical property taxes and maintenance fees.
Suppose in a couple of months you want to take a 5-year mortgage and that rate is now 4.25%. The new stress test qualifying rate used would then be 6.25%. And that would reduce your borrowing power by 9%, to roughly $494,000.
The Alternatives:
Variable rates are still low, and low enough that the MQR is still being used for the stress test, keeping your purchasing power higher. However, do expect variable rates to increase also in the coming months, so you’ll need some tolerance for the rate to go up. If you’re on a tight budget a variable may not be for you, even with the increased flexibility if offers.
Some credit unions and alternative lenders offer “no stress test” products. What this means is they qualify you at the contract rate instead. While this can increase purchasing power more, typically the cost of this is a higher overall contract rate to you, meaning you pay more every month.
Takeaways
Rates have been unnaturally low for the past few years during COVID, and no one ever expected them to stay around forever as they weren’t sustainable.
We were always stress testing your mortgage, so even with the low rates, we were showing your income could afford a higher payment. Staying within your means and picking the mortgage product and term that works best and makes the most financial sense to you is key.
If you don’t think you can stomach the change coming, then a 5 year fixed may be best for peace of mind, but always be cautious about potential penalties that can be charged should you break the mortgage in the middle of the term.
Using a broker like myself can help you work out what the best options available for you will be.
