Last month, people wanting to buy a home saw their purchasing power increase.
They can now borrow more money because they have to pass a lower “stress test” for their mortgage.
This is because the Bank of Canada dropped its benchmark five-year mortgage rate to 4.79 percent in August.
The rate serves as the basis of what is called a stress test.
To pass, home buyers have to prove that they can afford to make payments based on an interest rate higher than what a lender is giving them.
The slash in the five-year mortgage rate constitutes the third cut made by the central bank since the COVID-19 pandemic began.
The rate fell from 5.19 percent to 5.04 in March. Later in May, it went down to 4.94 percent.
Economist Will Dunning focuses on housing markets and has a strong interest in issues like stress tests.
The Toronto-based expert serves as the chief economist of Mortgage Professionals Canada, a national industry association representing more than 11,500 individuals and 1,000 companies. He also runs his personal consulting firm.
“It’s very good policy to do some testing of a mortgage borrower to make sure that they’re going to be able to afford payments in the future,” Dunning told the Georgia Straight in a phone interview.
According to Dunning, there are many things that could affect people’s ability to pay.
One of these is interest rates.
The economist said that it is sensible to test people against an interest rate that is “reasonably possible”, but not against a rate that is not going to rise as much.
Dunning pointed out that while new borrowers are now evaluated using an interest rate of 4.79 percent, the actual rates available in the market are below two percent.
“This is an impediment to many Canadians achieving their reasonable homebuying goals and is also an impediment to the broader economic recovery,” he said.
For him, this means one thing: the stress test needs to be updated to reflect current realities.
It’s time to recalibrate that policy to say, you know, what is a reasonable expectation about the conditions that will exist in five years and will affect people’s ability to make their payments,” Dunning said.
The economist argued that there doesn’t seem to be anybody who believes that rates would rise by almost three percent in the next five years.
In addition, Dunning said that the stress test “implicitly” does not consider rising incomes. According to him, incomes have been increasing in Canada for decades.
“It is omitting one of the most important factors that will affect people’s ability to make their future payment, and so that’s a major flaw in the testing system that exists today,” Dunning said.
In March 2020, Dunning released a report titled “Annual State of the Residential Mortgage Market in Canada: Year End 2019”.
At the time, the central bank’s benchmark five-year mortgage rate was 5.19 percent, while lenders were offering rates ranging from 2.5 percent to 2.85 percent.
With those rates, almost 20 percent of potential home buyers would not qualify, Dunning wrote.
“The actual outcome would probably differ from that estimate (depending, for example, on people’s willingness to lower their expectations or on their ability to find additional down payment funds),” the economist noted in the report.
In the same paper, Dunning said that the government has “not justified the assumption that in five years interest rates will be two (or more) percentage points higher”.
In March 2020, the Bank of Canada slashed its trend-setting “key rate” three times as a response to the pandemic. The key rate determines interest rates on loans given out by lenders to homebuyers.
From a rate of 1.75 percent at the start of March, the central bank ultimately brought it down to 0.25 percent. That’s the lowest level that can be set, and it has stayed there so far.
The bank will make a new announcement on Wednesday (September 9).
In his paper, Dunning noted that weekly wages in Canada have increased every year by an average of 2.6 percent.
He wrote that—based on Statistics Canada’s data on wages—the average total increase every five years has been 13.9 percent.
Because the stress tests do not take into consideration income growth, Dunning said that the government assumes there will be none during a five-year period.
According to the economist, such an assumption has a “very low probability”.
On the phone from Toronto, Dunning proposed a formula for what he considers a “reasonable stress test”.
“If you think interest rates might rise by two points over the next five years, and you also have an expectation that incomes will continue to rise the way they have in the past, then the way to simulate that combination is to say that the test should be the contracted interest rate plus three-quarters of a point,” he said.