This article has been updated from a previous version.
The Canadian government requires banks to “stress test” hopeful homebuyers to prove they can make mortgage payments if interest rates rise.
Given how high home prices are across much of the country, especially in major cities like Vancouver and Toronto, the stress test can make it harder for people to qualify for a mortgage. Saving enough for a down payment — which, in Canada, amounts to 5% of a home’s purchase price, or 10% on any amount above $500,000, and 20% on amounts of $1 million or more — is hard enough. A stress test that requires you to prove that you have even more money? It certainly doesn’t make things easier.
But maybe that’s not an entirely bad thing. It’s key to understand that the federal government did not introduce the stress test solely to be a downer; the test’s purpose is to weed out prospective homebuyers who are at risk of not being able to keep up with mortgage payments. After all, low mortgage qualification rates in the U.S., and the housing bubble that followed, were one of the triggers of the 2008 financial crisis — which led to massive job losses, devalued homes, and taxpayer-funded bank bailouts.
However, people still need a place to live. Suppose you’re tired of renting but find it hard to qualify for a mortgage from a traditional lender — e.g., a bank — under the stress test rules. In that case, the chances are that you’ve come across the terms shadow lenders, alternative lenders, and private lenders in your research.
Essentially, people are looking outside the traditional lenders to qualify for a mortgage. There’s nothing wrong with this going that route, but it’s important to understand what’s involved and any potential risks.
We’ve talked to Shawn Stillman, a mortgage broker at Toronto-based mortgage company Mortgage Outlet, to learn more about these lenders. Can you trust them? How do you know if you’re getting a good deal?
When you’re looking for a mortgage, there are a variety of different lenders. “A lenders,” or traditional lenders, refer to banks and credit unions that cater to customers with good credit scores and a reliable income — these are considered an “A” clientele. The majority of people looking for mortgages have traditionally gone to these lenders.
Institutions servicing an “A” clientele include Canada’s major banks (e.g., BMO, CIBC, National Bank of Canada, Scotiabank, RBC, and TD). These banks are subject to federal regulation, which means you’ll be stress tested when applying for a mortgage.
The stress test involves finding out if applicants can afford to pay interest at either the five-year average posted rate (5.25%) or two percentage points higher than the rate their bank or broker offers them — whichever is higher.
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Many credit unions also cater to a primarily “A” clientele, but they are not federally regulated. Provincial governments regulate them. While certain credit unions do not have to follow the stress test rules, some have reworked their mortgage lending guidelines to align with the regulations to protect their interests and customers.
Stillman says that established banks and credit unions typically lay out the terms of their mortgages very clearly. If you don’t understand a clause, ask questions until you do; never sign anything — especially anything as potentially life-changing as a mortgage — without understanding what it entails first, Stillman advises.
Equitable Bank and Home Capital are examples of institutions that offer options for a “B” clientele.
These institutions offer a lower barrier of entry to qualifying for their products but can offset that with higher interest rates. In short, they cater to people who may not be eligible for a mortgage or a credit card at one of Canada’s six big banks because they lack either strong credit history or a guaranteed income (recent immigrants, or the self-employed, for instance).
But when it comes to mortgages, the deal might be worse than traditional lenders. A mortgage is a loan given to you under specific conditions, and it’s necessary to understand what B lenders are offering to ensure that you won’t get trapped with high interest rates you can’t afford.
Unregulated or private lenders
Unregulated lenders could span anyone and anything from individual lenders like your parents or businesses specializing in mortgages but are not subject to the same regulations as banks and credit unions.
Stillman refers to this sector of the mortgage market as “the wild west.”
Unregulated lenders aren’t required to stress test mortgage applicants, but they tend to abide by lower qualification rates. Getting approved for a mortgage loan at an alternative lender can be much easier than getting approved for the same loan at a traditional bank or credit union.
As with B lenders, it’s imperative to pay close attention to the deal that an unregulated lender is offering you — in our experience, lower qualification rates tend to come with baggage.
What you need to look for when considering an alternative lender
Stillman identifies five questions that you should always ask when looking at a mortgage agreement:
- How high is the interest rate?
- What is the monthly mortgage payment?
- What is the prepayment penalty if you can’t make a mortgage payment? How is it calculated? What will it cost you to get out of the mortgage altogether?
- Is there a prepayment privilege — e.g., can you avoid paying penalties if you give the lender a larger mortgage payment for one month?
- What does the fine print say?
Do not sign anything until you have satisfactory answers to each of these questions. And again, if you don’t understand what you’re looking at — ask more questions; don’t be afraid to sound stupid.
Get a lawyer
Getting a lawyer is non-negotiable when you’re considering a private loan. And this folds neatly into the point about understanding what you’re signing up for: a lawyer you trust can help clarify, and potentially identify risky clauses.
“The number one thing that I always say is have your lawyer review the documents,” says Stillman.
“Not a lawyer that the lender suggests. You need a lawyer that represents your interests in these transactions.”
Know the mortgage rules in your province
Since private lenders are not subject to the same regulations as banks and credit unions, they can charge unconventional fees — some of which may turn out to be illegal.
In Ontario, for instance, it’s illegal for any mortgage brokerage to charge you an upfront fee if your mortgage amounts to $400,000 or less. Check the provincial regulations in your province to find out whether advance fees are legal or not.
About the author
Jessica Mach is a freelance writer for LowestRates.ca. She's covered the documentary film industry at realscreen, and her work has also appeared in The Hairpin.