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The new portfolio test to limit highly indebted borrowers applies to bank portfolios and not individual home buyers
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Published on March 25, 2024 • Last updated 29 minutes ago • 4 minutes reading time
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Canada's banking regulator is taking new steps to ensure lenders don't take on too many heavily indebted borrowers, especially as mortgage rates start to fall and it becomes easier to qualify for larger loans. The new portfolio test, implemented by the Office of the Superintendent of Financial Institutions, monitors the loan-to-income ratio quarterly to ensure that the percentage of a bank's uninsured mortgage loans exceeds 4.5 times the borrower's income , remains below a certain threshold. The Financial Post's Barbara Shecter explains the new test and what it means for banks and borrowers.
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Why is this happening?
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The change is one of a series of expected adjustments to mortgage guidelines that have been discussed since last year. According to OSFI, the new portfolio test is intended to “prevent the accumulation of highly leveraged loans during periods of low interest rates.” The regulator is particularly concerned about loans that are more than 4.5 times the borrower's income, as they increase the likelihood of the borrower defaulting and increase a lender's potential losses. As the ongoing period of low interest rates before steep increases beginning in spring 2022 shows, such debt may be manageable in a low interest rate environment, but becomes significantly more challenging for borrowers and their financial institutions when interest rates rise.
Does the test apply to borrowers like the interest-qualifying stress test?
No, the portfolio test does not create a new hurdle for the individual home buyer trying to qualify for a mortgage loan. Instead, it tracks banks' uninsured mortgage portfolios. “This action does not apply to any individual,” OSFI said in a March 22 statement. “It applies to the institution's portfolio of underwritten mortgages originated in this quarter… and must be managed by the institution.” Mortgage strategist Robert McLister said there is no prohibition on a person taking out a mortgage if the loan exceeds their income by more than 4.5 times. Even with the new test, banks could allow a single borrower to exceed the cap “as long as the entire portfolio averages 4.5 times or less,” he said.
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Will all banks be bound to the same cap?
OSFI is considering a 25 percent limit on originations that exceed the loan-to-income ratio threshold by 4.5 times for all banks, based on the total dollar value of quarterly originations. Instead, the regulator monitors banks individually and applies the test based on each institution's business model. The regulator says this approach will allow banks to continue to use existing underwriting methods in the current interest rate environment and compete as before.
What impact will this new test have on the mortgage market?
According to McLister, not much at first. However, this will be noticeable once interest rates start to fall, as the stress tests will result in a lower interest rate for individual borrowers, meaning the borrower will be eligible for a larger mortgage – and that means the ratio of loans to Income increases. Still, McLister said, there will be many borrowers who won't exceed a loan of 4.5 times income, especially if they have already paid off and rolled over part of their mortgage. This will lower the overall ratio for a bank's portfolio and allow them to make more high-leverage loans, he said.
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Are these loans a problem now?
According to an OSFI consultation document released in January 2023, industry-wide uninsured mortgages with these high loan-to-income ratio metrics had risen to an average share of more than 30 percent of new originations as home prices rose during the pandemic. But according to McLister, the proportion has fallen rapidly and is currently only 12.55 percent. The average loan-to-income ratio for uninsured borrowers is 2.6 times, he said.
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How are banks likely to react to the new portfolio test?
Some lenders may respond by charging certain borrowers with high loan-to-income ratios a surcharge to offset the implicit risk of a borrower whose loan far exceeds the income ratio cap, McLister said. A premium fee could also help the bank limit the number of highly indebted borrowers in its portfolio. “In general, in these exceptional cases, banks would probably want these to be higher value and/or more profitable customers,” he said, adding that this could lead some heavily indebted borrowers to instead seek loans from non-government regulated financial institutions or Non-prime financial institutions seek lenders.
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