Real Estate Investing

Stress Test Rate: What It Is & How to Lessen Its Impact


December 27, 2022

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Mortgage stress tests are an important part of the home-buying process in the United States. According to recent stats, 68.4% of households in the United States own their homes, and lenders originated 943,242 purchase mortgages in the third quarter of 2022.

To protect borrowers from taking on too much debt, lenders require them to pass a strict stress test known as the mortgage stress test rate. This rule requires borrowers to demonstrate that they can afford mortgage payments even if interest rates rise.

This article will discuss the stress test rate, its impact on borrowers, and how to lessen its impact.

What Is a Mortgage Stress Test and Why Is It Important?

As discussed above, the mortgage stress test rate is a measure used by lenders to determine if borrowers can afford their home loan payments should interest rates rise. To pass the stress test, borrowers must demonstrate that they can afford their mortgage payments at a higher rate than what is currently offered. In other words, the stress test predicts future affordability.

This is important because it helps lenders protect borrowers from being over-extended and unable to pay their mortgages. It also helps them protect themselves from having to repossess homes if borrowers default.

Calculating the Stress Test Rate and How It Affects Mortgage Affordability

When lenders calculate the mortgage stress test rate, they use either a rate of 5.25% or your actual rate plus two percentage points, whichever is higher. For example, if your current rate is 3.5%, the stress test rate would be 5.5%. To qualify for a mortgage loan, you must demonstrate that you can afford the payments at this higher rate.

The impact of the stress test rate on affordability can be significant. For example, let’s assume you’re looking for a loan of $500,000 at a rate of 3.5%. If you pass the stress test with a rate of 5.5%, your mortgage payment would be about $2,950 per month.

If you can only qualify for a loan of $400,000 at 3.5%, your mortgage payment would be about $2,360 per month, a difference of nearly 17%.

Ways to Lessen the Impact of the Mortgage Stress Test

Source: Pexels

There are some ways to lessen the impact of the stress test rate. Here are a few tips:

Adding a Co-Borrower to a Mortgage

One way to lessen the impact of a mortgage stress test is to add a co-borrower to the loan. While adding a co-borrower can help with qualifying for a larger loan, it's important to consider all of the pros and cons before making this decision.

Pros include improving your chances of being approved for a loan and having another source of income to help pay off the loan.

Cons include sharing responsibility and potential liabilities and possibly putting your co-borrower's credit score at risk.

Having a Down Payment Gifted by Immediate Family

Another way to lessen the impact of the mortgage stress test is to have a down payment gifted by immediate family. This can improve your debt-to-income ratio and make it easier to qualify for a loan. However, it’s important to note that you may still be required to prove you can afford the loan at a higher rate.

Longer Term Amortization 

By opting for a longer 30-year amortization, you can lower your payments and be approved for more mortgages. You can still benefit from the increased approval amount (approximately 15%) by making pre-payments after closing to reduce the effective amortization of your loan. This will help offset the effect of the stress test while also allowing you to pay off your mortgage sooner, such as in 25 years, 20 years, or even 10 years. 

What To Do If You Don’t Qualify For A Mortgage Because Of The Stress Test?

If you don’t qualify for a mortgage due to the stress test, some options are still available.

Shop Around

One option is to shop for a lender offering a lower rate or more favorable terms. It’s important to remember that rates offered by different lenders can vary greatly, so it pays to shop around.

Apply for a Smaller Loan

Another option is to apply for a smaller loan. This will help lower your payments and make it easier to qualify for the loan. But, you may have to make some compromises regarding which property or type of home you can buy.

Change the Parameters of the Mortgage

You can also look at changing the parameters of the mortgage. This could mean extending the amortization period or opting for a variable-rate mortgage or shared-equity mortgage. While these changes can help affordability, they also come with risks. 

Save For A Down Payment

If you don’t qualify for a mortgage because of the stress test, it may be worth saving up for a bigger down payment or waiting for the rates to fall. A larger down payment can help you qualify for a bigger loan and reduce your monthly payments. It’s also important to note that rates are subject to change, so it may be worth waiting until the situation improves before applying for a mortgage.

Key Takeaways

The mortgage stress test rate ensures borrowers can afford their mortgage payments.

  • It is important to understand the mortgage stress test rate, as it can greatly impact how much you can qualify for.
  • To calculate your stress test rate, lenders either use a rate of 5.25% or your actual rate plus 2%.
  • The mortgage stress test rate can significantly impact your ability to qualify for a loan.
  • The impact of the mortgage stress test can be reduced by adding a co-borrower to the loan, having a down payment gifted by immediate family, or opting for a longer amortization period.
  • If you can't qualify for a mortgage because of the stress test, you may have to shop around for a different lender, apply for a smaller loan, change the parameters of the mortgage or wait until you have saved up for a bigger down payment.
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