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How to stress test your mortgage

Signed contracts to buy existing homes increased just 0.4 percent in April, according to a monthly report from the National Association of Realtors.

Stress tests are usually associated with assessing someone’s heart function or the safety of bridges, nuclear power plants or global financial institutions. But the same concept — evaluating the stability of a system to find out where the breaking point lies — can be applied to mortgages too.

Toronto’s Kyle Knoeck is accustomed to this kind of strategy for his work as an urban planner. So when he was contemplating taking on a bigger mortgage, he put the stress test to work on his own numbers.

“The idea of doing sensitivity analysis is normal for me, looking at how different decisions will be affected by different scenarios,” Knoeck says. “I have a condo, and when we were looking at taking on a larger property I needed to understand how that would work.”

We know rates are going to rise, but we don’t know when. Stress-testing for the future rate hike is an exercise that financial experts and mortgage brokers recommend highly.

“We advise testing two per cent higher than your current rate,” Dayna Whitney, regional director at Meridian Credit Union, says via email. “It’s a precautionary test that follows the motto ‘better to be safe than sorry.’ No one can predict the future, but you can certainly prepare for it.”

Working with an advisor at Meridian, Knoeck asked and answered questions like: Would he be able to carry the mortgage if his condo sold for less than he hoped? How much would his mortgage payments be with a variable rate if interest rates were to go up significantly? What if he chose a term shorter than 25 years? How much would accelerated payments be?

Armed with information, Knoeck and his partner recently purchased a semi-detached house in central Toronto. Although it’s more mortgage than he’s had in the past, he can sleep at night.

“Buying and selling [real estate] should be a very rational experience, but usually it’s an emotional one too,” he says. “Stress testing is a strategy to tamp down on those emotions so you’re making a good decision as opposed to getting caught up in feelings that might not actually be smart financial decisions.

“I feel secure with the information I have at hand,” he adds. “I have no doubt I made a decision I can manage, and I’m not at all nervous about it despite having a bigger mortgage and having a house instead of a condo for the first time.

With interest rates certain to rise, Vancouver mortgage broker Karen Gibbard says every borrower, first-time or not, should consider all the variables.

“I believe that working out a scenario of what the family finances would look like with higher interest rates is a valuable exercise, especially when we’ve been sitting with such historically low interest rates,” says Gibbard, senior mortgage consultant at Gibbard Group Financial.

A simple way for people to do this, she says, is to work out what they think their maximum monthly payment could be and then work backward to see what that means in terms of an interest rate.

“If people can’t do this themselves -- they probably need a financial calculator to do it -- then they can call a mortgage professional and we can work it out fairly quickly,” Gibbard says.

Once a homeowner knows what their maximum interest rate is, to match their maximum mortgage payment, then they can gauge how close they are to that rate right now and make a decision what type of mortgage is best for their budget.

"If their current rate is close to their maximum rate range, then clients can consider taking a longer term to lock in the payments and rate for as long as possible, take the longest amortization possible … or work at paying off any outside debt to ensure they free up as much cash flow as possible to accommodate an increase in the interest rate and mortgage payments," Gibbard says.

Canada's new lending rules have already implemented a stress test in way, given that those who wish to take a variable rate mortgage or a fixed mortgage with a term less than five years are required to qualify with an artificially higher interest rate, currently 4.99 per cent.

“However, the qualification ratios don’t take into consideration a client’s lifestyle or other payments or debts outside of what is reported on the credit bureau report,” she notes.

The ideal time to stress-test a mortgage is before you buy, but that doesn’t mean you can’t do it after you’ve purchased a home, Whitney says.

“If you test before you purchase, it will let you know what you can and can’t afford,” she says. “If you test after you purchase, your results can help you re-evaluate your budget.”