Definition:
The qualifying rate is the interest rate used by lenders to determine whether a borrower can afford a mortgage. It is typically higher than the actual mortgage rate and is used in stress tests to assess a borrower’s ability to handle potential interest rate increases. In Canada, the qualifying rate is often based on the Bank of Canada’s benchmark rate or the posted rate by financial institutions.

How the qualifying rate works

When applying for a mortgage, lenders use the qualifying rate to evaluate whether the borrower can afford their mortgage payments under more challenging conditions, such as rising interest rates. This rate is usually set higher than the actual rate that the borrower will be charged. The qualifying rate is applied to calculate monthly payments, ensuring that borrowers would still be able to meet their obligations if rates were to increase in the future.

The goal of the qualifying rate is to prevent borrowers from becoming financially strained if interest rates rise after they’ve taken out the mortgage. This is particularly important for variable-rate mortgages or loans with adjustable terms, where payments may increase over time.

Why the qualifying rate is important

The qualifying rate is a key tool for lenders to assess the risk associated with lending money. It helps ensure:

• Borrower affordability: The rate ensures that borrowers can handle potential rate hikes without defaulting on their mortgage.
• Financial stability: By applying a higher qualifying rate, lenders reduce the risk of borrowers falling behind on their payments if interest rates rise significantly.
• Regulatory requirements: In Canada, the qualifying rate is part of the stress test requirements for insured and uninsured mortgages, which were implemented to improve the stability of the housing market and prevent over-leveraging.

How the qualifying rate is determined

In Canada, the qualifying rate is generally based on the Bank of Canada’s five-year benchmark rate or the posted rate by the lender, whichever is higher. The lender uses this rate to calculate the borrower’s affordability under the assumption that rates could rise in the future. This rate applies regardless of the mortgage type or the borrower’s credit score.

• Posted rate: This is the rate that a lender advertises to the public, which is often higher than the actual rate offered to the borrower.
• Stress test rate: The qualifying rate is commonly known as the stress test rate because it simulates a higher interest rate environment, ensuring that borrowers can still afford their mortgage payments if rates increase.

Qualifying rate and mortgage approval

When you apply for a mortgage, the lender will use the qualifying rate to assess your ability to make monthly payments based on the worst-case scenario of higher interest rates. If you can afford the payments at the qualifying rate, the lender will be more likely to approve your mortgage application.

• Higher qualifying rates: In a rising interest rate environment, the qualifying rate increases, which can make it more difficult to qualify for a mortgage, as your payments will be calculated at a higher rate.
• Lower qualifying rates: If interest rates are lower, the qualifying rate decreases, potentially making it easier for borrowers to qualify for a mortgage or borrow a larger amount.

Impact of the qualifying rate on borrowers

The qualifying rate can have a significant impact on how much a borrower is able to borrow. If the qualifying rate is higher, borrowers may be approved for a smaller loan, as their ability to afford the mortgage payments will be calculated based on the higher rate. Conversely, a lower qualifying rate allows for larger borrowing amounts since the monthly payment calculation assumes a lower interest rate.

For example, if the qualifying rate is 5.25% and you apply for a mortgage with an actual rate of 3.5%, the lender will calculate your mortgage affordability based on the 5.25% rate, making sure that you can handle higher payments if the rate increases.

Qualifying rate and government regulations

In Canada, the stress test for mortgage qualification requires that both insured and uninsured mortgages be tested against the qualifying rate. This has been a key measure introduced by the Office of the Superintendent of Financial Institutions (OSFI) to improve housing market stability and reduce the risk of borrowers overextending themselves.

For insured mortgages, the borrower must pass the stress test based on the higher of the lender’s posted rate or the Bank of Canada’s benchmark rate, plus 2%. For uninsured mortgages, the stress test is based on the same criteria, but the qualifying rate might differ depending on the lender’s internal policies.

When the qualifying rate changes

The qualifying rate can change when the Bank of Canada raises or lowers its key interest rate, or when lenders adjust their posted rates. This means that:

• An increase in the qualifying rate can make it more difficult for borrowers to qualify for a mortgage or reduce the amount they can borrow.
• A decrease in the qualifying rate can make it easier for borrowers to qualify for larger mortgages or more favorable loan terms.

Understanding the qualifying rate

The qualifying rate is an important part of the mortgage application process, especially in times of economic uncertainty. It ensures that borrowers are not overextended and helps maintain stability in the housing market. By understanding how the qualifying rate affects mortgage qualification, you can better prepare for the mortgage application process and determine how much you may be able to borrow.

Last modified: November 11, 2024