What would happen if the mortgage stress test was eliminated?

Sixteen months after the implementation of the federal government’s B-20 mortgage stress test regulations, TD Bank released an examination of its effects. Basically, the stress test did what it was supposed to do, but had some unintended consequences. 

The stress test was implemented to cool the runaway housing market. It did this. TD estimates that the stress test led to approximately 40,000 fewer home sales across Canada from the fourth quarter of 2017 to the last quarter of 2018. This equals about a 7% drop in sales on a national scale. 

This doesn’t seem like a big drop, but Canada’s most expensive markets - Ontario and British Columbia - took the hardest hit. Home sales in Ontario fell 20% after the stress test kicked in, and Toronto home sales plummeted 30%. There’s also rising interest rates and new provincial policy to take into consideration, but TD says the stress test was a primary factor in the slowing of sales.

The point of the stress test was to ensure people were buying homes they could afford, meaning they weren’t taking on more debt than they could handle. Obviously sales were going to slow down and some people were going to buy homes that were priced lower because of their weakened borrowing power. This makes sense and was expected.  

But, here are a few unintended consequences of the stress test:

Lower supply    

The resale market reacts to buyer intentions. If buyer’s can’t afford what’s on the market, or they’re deciding to rent for longer, than not as many homeowners will list their homes. Same goes for the new home market. Builders can only sell to people who are qualified to buy. Fewer sales in the new home market leads to fewer units hitting the rental market and resale market.

Tighter rental market 

First-time buyers took the biggest hit when the stress test came into effect. Their buying power was already the weakest compared to older generations. The problem is that they’re also a huge segment of the market, TD estimates typically 40% to 50%. 

TD says that average purchasing power decreased by 20%. That means a significant chunk of these would-be buyers were forced to the sidelines, which results in fewer rental units on the market. The rental market was tight before the stress test, so things only got worse as vacancies dropped and rents soared. 

More activity with alternative/private lenders

Alternative/private lenders are not required to factor in the stress test. The problem is that these lenders tend to have higher rates. If more households are going with private lenders, it means they could be taking on way too much debt. 

Eliminating the mortgage stress test

According to TD, if the stress test was eliminated, national home sales would increase 8% and home prices would increase 6% by the end of 2020. TD is already forecasting the average home price to rise 4% by the end of 2020 with the stress test in effect. First-time buyers would definitely have stronger buying and borrowing power, which would lead to more rental units on the market.

All sounds good, except TD warns that removal of the stress test would result in worsened affordability in the long-term. TD’s recommendation is to maintain “flexibility going forward with respect to tweaking the B-20 rules, especially if circumstances change or if housing markets continue to undershoot expectations.”