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Introduction
In Canada, 39% of households have a mortgage (Statistics Canada 2024). For these households, mortgage payments typically represent their single largest regular expenditure. Ensuring that households can make these payments is critical for financial stability because nonpayment can lead to credit losses for lenders. To improve the resilience of the mortgage market, and the banking system more generally, regulatory authorities have for over a decade required federally regulated lenders to perform mortgage stress tests, a form of macroprudential policy.
Put simply, mortgage stress tests assess whether households have sufficient flexibility in their budget to make larger mortgage payments than what is determined by their financial institution when they sign a mortgage contract. Households must demonstrate they can sustain mortgage payments calculated using, in most cases, a higher mortgage interest rate than the one offered by lenders on their proposed contract. This additional financial flexibility could likely help households cope with either a reduction in income or an increase in expenditures such as mortgage payments.
From the 2010s onward, the Government of Canada and the Office of the Superintendent of Financial Institutions (OSFI) introduced successive policies that gradually led to most mortgage originations by federally regulated financial institutions (FRFIs) being subject to stress tests. The two major policies involving the stress tests were implemented in 2016 and 2018. From a research standpoint, they provide an interesting opportunity to evaluate the impact on mortgage markets and house prices. This analysis not only assesses the intended effects of the implemented policies, but also expands the evaluation to multiple indicators, offering a broad understanding of the impact of such policies.
In the spring of 2022, the Bank of Canada and other central banks started to significantly raise policy interest rates, which led to substantially higher mortgage interest rates. This situation offers a similarly valuable opportunity to assess the impact of mortgage stress tests on the financial resilience of Canadian mortgage borrowers to higher interest rates.
Leveraging data on mortgage originations, we find that mortgage stress tests, when applied to most mortgage purchase originations, improve credit quality and reduce both credit growth and house price growth. They also improve the resilience of borrowers to financial shocks, such as the large increase in interest rates over the 2022–23 period.
In particular, we show the following:
- The 2016 mortgage stress tests—a policy implemented only for insured mortgages—resulted in an improvement in standard measures of credit quality for new mortgages, such as credit scores and the distribution of loan-to-value (LTV) and debt service ratios. However, due to its narrow scope, this policy had a limited impact on the mortgage market because it did not contribute to slowing down growth in mortgage credit and house prices in Canada.
- The 2018 mortgage stress tests—a policy implemented for uninsured mortgages—improved credit quality across the entire mortgage portfolio, as intended. But it also had broader implications since it led to lower mortgage credit and house price growth.
- In the context of the monetary policy tightening that started in March 2022mortgage stress tests are effective in ensuring that households can successfully manage increases in mortgage payments without falling behind on their credit obligations. Specifically, following the rise in the Canadian policy interest rate, geographical areas more exposed to the 2016 policy experienced a lower increase in credit delinquencies than less exposed areas did. This difference is particularly pronounced for delinquencies on credit cards and auto loans and for borrowers holding mortgages with LTV ratios above 80%.
The mortgage stress tests
In Canada, residential mortgages are generally subject to robust underwriting practices and regulatory constraints aimed at increasing the likelihood that borrowers are able to repay their debt obligations. This ability is formally assessed through calculation of two debt service ratios, namely:
- the gross debt service (GDS) ratio—the share of income devoted to mortgage payments and other housing costs (such as property taxes, heating costs and condo fees, if applicable)
- the total debt service (TDS) ratio—the share of income allocated to all (both mortgage and non-mortgage) debt payments and other housing costs
Insured mortgages face limits on GDS and TDS ratios of 39% and 44%, respectively. Mortgage stress tests change how these debt service ratios are computed. For mortgages subject to the stress tests, debt service ratios are calculated using a rate (the stress test rate) that may be higher than the contractual one. While the stress test rate does not directly affect mortgage payments, it results in higher qualifying debt service ratios, potentially limiting the maximum loan amount for which a borrower can qualify or requiring a larger down payment.
As detailed in the June 2018 Bank of Canada Financial System Review (Box 1), the policies for stress testing government-backed insured and uninsured mortgages were characterized by the following:
- Before 2016, the Government of Canada and OSFI mandated stress tests to be applied to high- and low-ratio mortgages, either with variable rates or with fixed rates with terms of less than five years.
- From October 2016 onward, the Government of Canada expanded the scope of stress tests to include all government-backed insured mortgages.
- From January 2018 onward, OSFI issued an update to Guideline B-20, requiring FRFIs to stress test uninsured low-ratio, fixed-rate mortgages with terms of five years or more. In other words, banks were required to underwrite these mortgages based on stress-tested debt service ratios, despite these mortgages not being subject to the regulatory limits described above.
The stress test rate, also known as the minimum qualifying rate (MQR), was also modified over time:
- Before January 2018, it was the higher value between the contractual rate and the MQR floor (the mode of the five-year mortgage rates posted by the Big Six Canadian banks) for all mortgages subjected to stress tests.
- After January 2018, it was the higher value between the contractual rate plus 200 basis points and the MQR floor for all low-ratio mortgages. For high-ratio mortgages, the stress test rate remained the higher value between the contractual rate and the MQR floor.
- After June 2021, the MQR floor was set at a fixed value of 5.25% for both high- and low-ratio mortgages (see Chart 1).