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The less risk-tolerant you are, the more a five-year fixed mortgage makes sense. That’s usually how it works.

But as it turns out, policy makers have inadvertently incentivized higher-risk borrowers into choosing short-term or variable mortgages, in a rising-rate market no less.

Here’s what they’ve done

Any lender that uses federally regulated funds, like a bank or a non-bank that sells mortgages to a bank, must make borrowers prove they can afford a mortgage payment at the federal “stress test” rate.

The stress test rate is the higher of your actual mortgage rate plus two percentage points or the minimum qualifying rate, which is currently 5.25 per cent.

With five-year fixed rates zooming up to 3.69 per cent – an average uninsured rate – the effective stress test for most five-year borrowers has risen to around 5.69 per cent.

The difference between 5.69 and 5.25 may not sound like much, but if you’re a homebuyer with higher-than-average debt – relative to your income – it can make or break your mortgage approval.

An example of how it works

If a family walks into a bank with $135,000 of income, 20-per-cent down, good jobs and credit and no other debt, they’ll get approved for enough mortgage to buy the average Canadian home of $816,720 – but only if they chose a variable or shorter-term mortgage.

That’s because most variable, one-year and two-year fixed mortgage rates are more than two percentage points below the minimum qualifying rate, which means they are stress-tested at the minimum 5.25 per cent.

But what if that same family wants greater security from a five-year fixed?

To get this added rate protection they’d have to prove they could afford a higher 5.69-per-cent payment. If they had no other source of income or down payment, they’d have to settle for a maximum purchase that’s 4 per cent less, or $785,000.

This loss of relative buying power will worsen as five-year fixed rates rise further, unless regulators change the stress test.

Indeed, the desire to qualify for bigger mortgages is why the minority of fringe borrowers are flocking to variable and short-term rates. But a higher debt load is generally not compatible with taking on more interest rate exposure.

This is something regulators could have avoided by setting the same stress test for all terms, at the average five-year fixed rate plus 200 basis points, for example. (A basis point is 1/100th of a percentage point.)

Other ways borrowers are beating the stress test

When a variable or short-term rate isn’t enough to qualify, and a borrower has no better options, they’re increasingly turning to lenders that aren’t bound by the federal stress test.

In most large provinces, there are multiple lenders that will qualify you at less than the stress test rate, the least expensive of which are credit unions.

A minority of credit unions still qualify borrowers at the contract rate, the largest being Ontario’s Meridian Credit Union, which advertises that “we don’t disqualify people for mortgages based solely on the results of the stress test.”

Meridian considers factors, such as potential income appreciation and other assets, to allow borrowers to qualify at five-year fixed rates as low as 4.04 per cent. That lets a homebuyer afford a home that’s up to 14 per cent more than a bank borrower, or $131,000 more than our example above – a tempting proposition for a family struggling to outbid the competition.

Lenders understand risk

Lest one feel that credit unions are reckless for stress-testing borrowers at the contract rate, that’s anything but the truth. For decades, this practice was commonplace for all lenders, prior to 2018.

Moreover, provincial regulators keep a sharp eye on credit union loan performance. “Default rates at credit unions are less than half of what banks are on mortgage financing,” says Michael Hatch, vice-president of government relations at the Canadian Credit Union Association.

For those who need even more flexibility than a credit union can offer, alternative lenders such as NPX are even more flexible. Not only do they stress-test borrowers at the contract rate (a rate in the mid-4-per-cent range), but they allow higher debt ratio limits (50 per cent instead of 44 per cent). You’ll need a 680-plus credit score, provable income and at least 20-per-cent down to qualify.

“With high home prices and rising rates, we’re seeing strong demand for non-OSFI compliant financing,” says Bryan DeVries, senior vice-president of alternative lending at MERIX Financial/NPX. (OSFI is the Office of the Superintendent of Financial Institutions, which sets the stress test for uninsured mortgages.) “As interest rates go up, getting approved for a mortgage becomes more important than the rate on the mortgage.”

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For a 30-basis-points-higher mortgage rate, NPX will even let you qualify using a 40-year amortization, versus 30 years at the banks.

And if you have 35-per-cent down, they offer interest-only payments, even on rental properties. But the rate is less savoury – in the mid-5-per-cent range.

Alternative lenders also charge fees, typically 1 per cent of the mortgage amount.

Get ready for new mortgage policies

“Housing affordability remains a priority for the federal government,” Adrienne Vaupshas, press-secretary for the Finance Minister says. “… We will take further action in the upcoming budget,” which is to be released on April 7.

Among other things, that action could potentially include some of the Liberals’ proposals, including:

– A 25-per-cent reduction in mortgage default insurance premiums (bad idea).

– A 25-per-cent increase in the insurability limit, to $1.25-million (good idea).

– A new tax-free First Home Savings Account (bad idea).

– More housing creation incentives (good idea, if they help the middle class, too).

– A new First-Time Home Buyer Incentive loan (bad idea).

– A doubling of the First-Time Home Buyers Tax Credit, to $10,000 (bad idea).

Most of these measures get a thumbs down for one simple reason. Added taxpayer-subsidized housing demand won’t fix what’s broken in Canada’s housing market.

Instead, we need a government that focuses on incentivizing more construction and commuter transportation – to keep up with its supersized immigration quotas.

Rates this week

If you’re buying with less than 20 per cent down, mind the gap between default insured five-year fixed and variable rates. It’s grown to a whopping 215 basis points, the widest since 2010.

This widening gap largely reflects inflation fear in the bond market, a fear that risk-averse borrowers must respect.

For those who can handle the thought of 300-plus-basis-point higher rates, 1.24 per cent may be suitable. Indeed, it may be hard to pass up, given the rising probability of recession and prime rate cuts in the latter half of a five-year term.

Lowest nationally available mortgage rates

1-year fixed2.79%Various Banks2.59%True North
2-year fixed2.89%CIBC2.79%Radius Financial
3-year fixed3.31%Canada Life3.19%QuestMortgage
4-year fixed3.39%Canada Life3.29%Canada Life
5-year fixed3.49%Alterna Bank3.39%Canada Life
10-year fixed4.14%HSBC3.84%Nesto
Variable1.94%HSBC1.24%True North
5-year hybrid2.79%HSBC2.84%Scotia eHOME

As of March 30.

Rates are as of Wednesday, from providers that advertise rates online and lend in at least nine provinces. Insured rates apply to those buying with less than a 20-per-cent down payment, or those switching a pre-existing insured mortgage to a new lender. Uninsured rates apply to refinances and purchases over $1-million and may include applicable lender rate premiums. For providers whose rates vary by province, their highest rate is shown.

This & that

  • 64 per cent of those polled are concerned about interest rates rising in the coming year, says the Royal Bank of Canada. That’s up 10 percentage points from last year.

Robert McLister is an interest rate analyst, mortgage strategist and columnist. You can follow him on Twitter at @RobMcLister.

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