OSFI looks to further tighten mortgage rules

Canada’s bank regulator proposes new restrictions on mortgages to safeguard housing finance in Canada.

On January 12, 2023, the Office of the Superintendent of Financial Institutions (“OSFI”), Canada’s bank regulator, released a consultation paper that includes proposals to tighten mortgage lending rules and deal with increased lending risks in the real estate sector. Since 2012, when OSFI first introduced the mortgage “stress test” in Guideline B-20, and again in 2018 when it added new thresholds, OSFI has been taking steps to encourage Canadians to reduce their dependence on residential mortgage debt. One consequence of this is that it may be harder for some Canadians to get a mortgage.

OSFI’s three proposals include:

• Loan-to-income (LTI) and debt-to-income (DTI) restrictions
• Debt service coverage limits
• Interest rate affordability stress tests

Loan-to-income (“LTI”) and debt-to-income (“DTI”) restrictions

OSFI has proposed introducing a “lender-level” limit by restricting mortgage debt and total indebtedness as a multiple or percentage of borrower income. Limits on LTI, which means mortgage debt relative to borrower income, and DTI, which means total indebtedness—including mortgage debt—relative to borrower’s income, are imposed to control the extent of a borrower’s indebtedness. OSFI’s stated aim is to reduce the likelihood of borrower default by making ongoing debt payments more manageable.

Specifically, OSFI is considering adopting a LTI a lender-level threshold of 450%, subject to a 25% quarterly volume limit on originations that exceed that threshold. Currently, banks and other Federally Regulated Financial Institutions (“FRFIs”) do not have prescribed LTI or DTI limits. LTI of 450%, which is when a homebuyer borrows more than 4.5 times their annual income, is typically considered “high.” LTI has been on the rise since the onset of COVID-19 pandemic. According to OSFI, since March 2020, one-third of mortgage originations are above the 450% threshold.

Currently, FRFIs can stretch DTI ratios as high as 600% if there is significant equity in the property. For instance, if a property has a value of $1,000,000 and the mortgage balance is less than $500,000, someone with an income of $100,000 could borrow up to $600,000. With the new proposed LTI and DTI threshold of 450%, the same borrower would only be able to obtain loan up to $450,000, even if the property has significant home equity.

Debt service coverage restrictions

OSFI has also proposed measures that restrict ongoing debt service obligations such as principal, interest, and other related expenses as a percentage of borrower income. OSFI would like to toughen criteria that evaluate a borrower’s ability to pay their mortgage loan and other expenses, sometimes referred to as debt service metrics.

Currently, lenders must employ Gross Debt Service (“GDS”) and Total Debt Service (“TDS”) limits for insured mortgages, on properties where there is less than a 20% cash down payment, at 39% and 44%, respectively. GDS is the percentage of a borrower’s monthly household income that covers housing costs, whereas TDS is the percentage of a borrower’s monthly household income that covers the housing costs and any debt and service costs (interest, minimum payment, instalments etc.).

There are no set limits on GDS and TDS for uninsured mortgages, which are for properties with down payments greater than 20% of the value of the property. OSFI generally permits banks and other lending institutions to establish debt-serviceability metrics by assessing a borrower’s capacity to make loan payments. OSFI has proposed implementing such limits on uninsured mortgages as well, in graduated or tiered amounts. It is also considering tweaking definitions and formulas for calculating gross and total debt service.

If implemented, OSFI would periodically review GDS and TDS limits to ensure they remain suitable for the prevailing risk environment. OSFI is also exploring whether high debt service ratio lending could be addressed through the capital framework, such that more capital is set aside for high GDS and TDS loans. OSFI is further considering limiting lenders to a certain volume of loans with high debt-service ratios. This will give lenders less discretion to deal with uninsured borrowers and further tighten the rules on those borrowers.

Interest rate affordability stress tests

OSFI has also proposed changing the mortgage stress test so that it would correspond more closely with a loan’s level of risk. The mortgage stress test is a test that requires borrowers to prove that they can make their monthly payments at an interest rate at least 2% higher than their actual mortgage rate. It was first introduced during the 2016-2017 real estate frenzy in Toronto and Vancouver.

Currently, the minimum qualifying rate (“MQR”) for an uninsured mortgage is the greater of the contract rate plus 2%, or 5.25%. The MQR is applied in the GDS calculation (i.e., mortgage-related debt service) at underwriting. OSFI has suggested enforcing more risk-sensitive stress tests. In December 2022, OSFI opted to maintain the qualifying rate for its mortgage stress test despite requests to lower it. With mortgage rates at around 5% currently, borrowers have to qualify for upwards of 7% in some cases.

OSFI has proposed introducing higher affordability stress tests that may be applied differently for various risk and product characteristics. If implemented, its new measures would limit what some borrowers qualify for, potentially keeping housing prices down. OSFI is hoping to better respond to underlying risk with the new stress test.

OSFI is also exploring whether lenders should apply MQR rather than the actual interest rate to non-mortgage debt when calculating a borrower’s total debt servicing ability. It has also suggested creating an explicit principles-based expectation that lenders establish, monitor, and report on different MQRs, in addition to the current MQR, for different risk product types.

Key takeaways

What is the potential impact?

Economists and mortgage analysts expect that the new restrictions could incrementally impact people’s ability to borrow. With interest rates more than doubling in a year, many Canadians no longer qualify for a mortgage. Further restricting mortgage eligibility will place many prospective buyers out of the market and increase monthly expenses for mortgage holders.

Furthermore, with the new higher LTI and DTI thresholds, many lenders would have to modify their portfolios on uninsured loans. Although OSFI is hoping to reduce the potential for migration of lending activity to the unregulated lending sphere by imposing such limits, borrowers might need to look for loans in private lending institutions that have significantly higher borrowing costs.

Some economists worry that the proposed measures would only provide protection mechanisms for lenders, not for homeowners. Average Canadian home prices fell 22.4% over the past nine months since the interest rate increased to 4.25%. Economists worry that decline in housing prices could complicate issues for many Canadians who are cash-strapped, as mortgage debt could be close to or even outstrip their property values. 

What are the next steps?

OSFI has announced that these are modest changes, which will take around 1.5 years to transition into mortgage products. According to Bank of Canada, approximately 11% of the secured loans make up the residential mortgage portfolio in Canada. At this point, it is unknown how much of the 11% will be impacted by the new restrictions, if implemented.

OSFI is seeking stakeholder input, and its proposals are open for comment until April 14, 2023. OSFI is yet to disclose how long it would take to review the comments or issue new rules.

For further information on the consultation paper, please speak with one of our Financial Services group team members.