This post is guest-written by Chris Stapleton, Noctis Real Estate
Are you a first-time home buyer worried about the stress test? Don’t panic, this article will help explain what the stress test is and how it impacts first time home buyers, as well as creative ways millennials are entering the market despite it.
What is the stress test?
The Mortgage Stress Test was first introduced in October 2016 and initially only applied to insured mortgages provided by federally regulated financial institutions. It required those who apply for a mortgage with a down payment of less than 20% be qualified at the Bank of Canada’s conventional five-year posted rate (5.19% as of July 31, 2019) if the rate they were applying for was less than the five-year posted rate.
In January 2018, the "new" stress test was introduced and required all mortgages provided by federally regulated financial institutions be stress tested. This meant the same rules applied for insured mortgages as before, but that uninsured mortgages (those with 20% down payment or more) would also now need to be stress tested. For uninsured mortgages, the rate at which you must now qualify is whichever is higher: either The Bank of Canada's conventional five-year rate or the mortgage rate you are applying for plus 200 Basis Points (200 BPS = 2%).
This means that if you negotiate a mortgage rate of 3.00%* with your lender and provide a 20% downpayment, the rate you must qualify for to receive the 3% rate would be 5.19%, as in this case the Bank of Canada rate is higher than the negotiated rate plus 2%.
*Rate used for demonstration purposes only and may not reflect current mortgage rates.
What is the average millennial like?
A millennial is anyone born between the years of 1981 and 1996. According to Statistics Canada, the average millennial in Canada earned a median after tax household income of $66,500 in 2016, adjusted for inflation that’s about $70,000 per year in 2019. This same average millennial has a median debt of $35,000 and an average debt to after tax income ratio of 216% (Stats Canada 2016). This is a higher percentage than any other generation at any point in their life. Another key aspect of millennials is your level of education. Approximately three quarters of millennials have some form of post-secondary education.
However, with this comes student loan debt, of which 24.4% of millennial households (age 30-34) carried student debt, with a median value of $12,000. The final defining factor of millennials is the cost of living and income disparity you face. This higher cost of living has a major effect on your ability to save, as this higher cost of living has been present from the beginning of your saving years, including rental prices averaging $2,000 plus for a 1-bedroom apartment in big cities like Toronto in 2019. This means the total amount available for saving is typically lower than previous generations. Lastly, millennials face a much more pronounced income disparity, with the bottom 25% having an average net worth of only $9,500 and the top 10% holding 55% of the total net worth of all millennials.
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What does the stress test mean for millennials?
Now that you have a decent idea of the typical millennial in terms of income, debt, cost of living and ability to save, let’s talk about how the stress test impacts us.
There are three main ways the stress test impacts millennials: reduced buying power, delayed entry into the market and the need for alternative financing.
First, it means millennials can now get a lot less for their income and in some cases, means they cannot actually be approved for a large enough mortgage to purchase what they want. This is a result of the stress test reducing millennials ‘buying power’ (the maximum amount of house you can afford) by requiring they be approved for a higher rate than the one they receive. For example, if an individual pre-stress test were applying for a rate of 3%, that is the rate at which they would need to qualify, however, with the introduction of the stress test, this same individual now needs to qualify at 5.19% to receive this same rate of 3%. Basically, there is now a buffer between the mortgage amount a person can actually afford and the amount the bank is able to provide them.
The second way it impacts millennials is by increasing the amount millennials need to save to enter the market, and typically the time in which it takes for them to enter the market. Due to reduced buying power, millennials are required to save larger down payments in order to be approved for a substantial enough mortgage to match todays housing prices.
The final way the stress test impacts millennials is by forcing more and more people to seek out alternative/private lenders. For anyone either not approved for a mortgage due to higher qualifying requirements or not approved for a large enough mortgage to purchase the house they want, alternative or private lenders become their next option. Alternative and private lenders are non-federally regulated lenders who provide mortgages to those unable to be approved by traditional mortgage providers. These lenders typically charge a rate that is 0.5-1% higher and may charge additional fees equaling up to 1% of the total mortgage amount. These alternative lenders can help millennials be approved for a large enough mortgage to purchase the property type they want, but typically means the total interest they pay on their mortgage is higher.
What are Millennials doing to counter this? Mortgage Dos and don'ts for millennials
Despite the additional barriers the stress test presents, there are plenty of millennials using a bit of creativity to traverse those barriers and purchase property of their own.
Millennial Mortgage Dos
1. Seek out Government Incentives. There are three main incentives provided to Canadians that help reduce the upfront cost of purchasing a home for first-time home buyers and reduce the time needed to save prior to entering the market.
First-time home buyer’s incentive: This is a brand-new incentive offered by CMHC starting September 2, 2019, where by qualified first-time home buyers who have saved the minimum 5% down payment can apply for the government to finance between 5-10% of additional down payment in return for an equity stake in the property. This incentive is primarily meant to encourage the construction and purchase of new homes, therefore for resale, the available amount is up to 5% and for new construction between 5-10% of downpayment is available. There are no ongoing payments, but the loan must be repaid within 25 years or at the time of sale. The individual can choose to repay the borrowed portion at any point, interest-free and without any pre-payment penalties. Since the financing is provided in return for an equity stake in the property, the government also benefits from any appreciation on the property in proportion to the amount of equity owned. This incentive is available to first-time home buyers with a household income up to $120,000 applying for a mortgage that is no greater than four times the amount of their annual household income, to a maximum of $480,000. According to CMHC, for a family purchasing a $500,000 home, this program can save them approx. $3,500/ year.
First-time home buyers credit: This incentive was rolled out in 2009 and is aimed at helping cover the closing costs associated with purchasing a space (land transfer costs, legal fees etc.). This incentive allows an individual to claim up to $5,000 of the value of their home as an income tax credit in the year of purchase, and provides up to $750 in federal tax relief. To receive the credit the home must qualify and the purchaser must not have lived in a home owned by them or their spouse/common law partner within the four years prior to purchase.
Home buyers plan: The final government incentive is the home buyer plan, which allows an individual to withdraw up to $35,000 from their RRSP to buy/build a home.
2. Co-ownership. For those looking to enter the market at the same time as their friends or family members, co ownership, where multiple people purchase and share a house, is an option being taken by more and more millennials. This allows the group to save a reasonable downpayment faster and can potentially open the group up to be approved for a lower mortgage rate due to greater amount of income supporting the mortgage. Ownership is then either under joint tenancy or tenancy in common. In the future, the group can sell the property and use the cash for a new down payment, purchase out the other owner(s), or take out an equity loan to finance another down payment.
3. Pre-construction. For those who can’t wait years to save for their down payment, pre-construction can be an appealing option. Most pre-construction require a down payment of 20%, but do not require a total upfront payment, instead periodic payments based on the stages of the project’s completion are common place. For example, a 5% deposit provided at the time of signing, with several additional payments over a set period afterwards. This option allows for an individual to enter the market without the need to save a complete down payment, while in certain markets, benefitting from a lower total cost than a comparable re-sale condo. In addition, for condos less then 2 years from completion, a buyer can seek a letter of commitment from their bank to honour the rate provided with their current pre-approval at the time of occupancy, which can lead to a lower monthly rate. Condo developers also commonly have their own incentives they will offer potential buyers.
4. Seek out alternative financing. This is because the stress test only applies to federally regulated financers and not organizations such as credit unions or private lenders. Although you will still need to save for your downpayment, and typically alternative lenders charge a higher rate, it does mean you can potentially shirk the stress test and only be approved for the rate you are taking. Your monthly costs will likely be higher, but your buying power will increase, as you can be approved for a higher total mortgage than with a traditional mortgage.
Bonus: If at all possible… look to a family member. This can play out in a couple ways, but the most common is a “gift” allowing you to hit the 20% down payment amount, avoiding insurance and lowering your monthly payments. The other option is for a family member to provide a private loan to you at market rate. This allows you to avoid having to qualify at a higher rate and means there is no minimum down payment requirement.
Millennial Mortgage Don’ts
1. Switching jobs.Yes, millennials like to hop around when it comes to their careers! But if you’re considering switching jobs, it’s best to wait until after your mortgage is funded. Quitting your job in the middle of a mortgage deal can have terrible consequences. The lender is using your income at your present job to qualify you for the mortgage, and if you’re on probation at your new job, your lender may not allow you to use that income for qualification purposes.
2. Making a big purchase on your credit card. You’ve found your dream home – yes! We know it can be tempting to make a purchase on your credit card, like that awesome TV or couch, but it’s best to avoid big purchases until after your mortgage has been funded. While you’re applying for a mortgage, you want to make sure your credit utilization – how much of your available credit your using – is low to ensure your credit score is in the best shape possible.
The bottom line when it comes to millennials and mortgage rates
So, there you have it my fellow (now empowered) millennials! That's a full rundown of what the stress test is, how it impacts you and your mortgage rates, and a handful of ways that millennials are still managing to find a path to homeownership despite the stress…test.
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