Canada’s banking regulator has modified its controversial new mortgage stress-testing rule, ensuring home buyers will not have an unintended incentive to sign up for shorter-term mortgages.

The Office of the Superintendent of Financial Institutions published revised final guidelines Tuesday for its mortgage qualification rule, which requires buyers making down payments of more than 20 per cent of a home’s value – who do not need mortgage insurance – to prove they could still afford their mortgage payments if interest rates were 200 basis points (two percentage points) higher than the rate they negotiated.

Some real estate and lending organizations criticized the proposal because they said it would give borrowers an incentive to favour shorter-term mortgages because they typically have lower interest rates, making it easier to pass the stress-test standard. Critics said it would leave borrowers in a riskier position because they would be more vulnerable to interest rate increases with mortgages that come up for renewal more often.

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In the final version of the guidelines Tuesday, OSFI added an additional feature to its original proposal, saying buyers would have to qualify at the greater of the five-year benchmark rate published by the Bank of Canada or the original contractual rate plus 2 per cent. That means borrowers seeking short-term mortgages would still have to meet a higher stress-test hurdle, removing the benefit of choosing a shorter term.

OSFI superintendent Jeremy Rudin said the original proposal would have meant someone who wanted to borrow right up to their maximum limit would have had an incentive to search out the lowest-possible interest rate, which “might well” be the shortest-term mortgage.

“We didn’t want to create an artificial incentive for borrowers to shorten term because of the regulation,” Mr. Rudin told reporters on a conference call Tuesday morning.

Mr. Rudin said OSFI has made the mortgage changes because it was concerned about the risks to the lending system that are posed by high household indebtedness, rising interest rates and growing property values in some large cities.

“While we think sound underwriting is always important, in these circumstances it’s really never been more important than it is now,” he said.

The new lending rules will take effect Jan. 1, 2018. OSFI said it received more than 200 submissions to its original proposal, published in July.

Industry stakeholders expressed concerns about the original proposal, saying they would be punitive to borrowers. Groups representing home builders, real estate agents and credit unions all voiced their misgivings about the original proposal, with some warning that less-wealthy home buyers could be shut out of the market or forced to accept less-favourable loan terms.

But the leaders of Canada’s largest banks – which are only expected to be minimally impacted by the changes – have generally been supportive of OSFI’s new guideline. On Monday, Royal Bank of Canada chief executive officer Dave McKay said it “is in all our interests” to further dampen rapid growth in housing prices in order to ensure Canada’s long-term growth and competitiveness.

Critics had urged OSFI to hold off on the revisions, arguing too many other changes had already been introduced in the housing sector in the past year, and the industry needed time to absorb the impact.

While OSFI moved ahead, Mr. Rudin said the regulator is done with its changes to mortgage guidelines. But he said if market conditions change, they could require review.

He acknowledged that some borrowers who are considered less credit-worthy might migrate to lenders that aren’t federally regulated, and which typically offer higher interest rates on loans. “That would not be an intended consequence, nor would it be a completely unanticipated consequence,” he said.

But while OSFI has “ongoing contacts” with provincial regulators that oversee many credit unions and alternative borrowers, Mr. Rudin made it clear he thinks federally-regulated lenders are his sole responsibility. “We can’t control what we can’t control,” he said.

On Monday, RBC’s Mr. McKay voiced his concern that if risky borrowers simply migrate to alternative lenders outside federal regulations, “then you haven’t solved the problem, have you? So that’s the back door to this whole strategy that they have to be careful of.”

Mr. Rudin countered that if borrowers find other alternatives to get a mortgage, “there’s no loss there.” From his perspective, moving high-risk borrowers out of institutions OSFI regulates “has got to be good for the stability of the federally-regulated sphere,” he said.

“We are very aware of the potential, let’s call it, migration risk,” he added. “And as I said, that does not change our mind that this is a valuable initiative. It might be even more valuable if we didn’t have the migration issue, but it’s still net positive.”

Should interest rates rise significantly, OSFI is prepared to “revisit” the stress test, Mr. Rudin said, but he expects the new rules to be “durable” in the near term. Yet some industry observers wonder whether the regulator is equipped to respond quickly enough to rising rates.

“The fear is that if OSFI does revisit the stress test, it could be too late,” said Rob McLister, founder of RateSpy.com, a mortgage-rate comparison website. “By the time rates surge [by 150 to 200 basis points or more], a whole swath of buyers would already be shut out of the market leaving home prices to fall on their own weight before the regulator can react.”

Financial services analyst Robert Sedran from Canadian Imperial Bank of Commerce said there is no doubt new mortgage growth will slow in Canada as more people qualify for smaller mortgage amounts under the rules, but said the question now is the impact they will have in combination with several other regulatory changes that have been introduced in the past year by various levels of government.

“Our only remaining concern is the risk that all these changes will act in concert to create a more pronounced slowdown than any one regulatory body intended,” he wrote in a research note Tuesday. “The answer to that question will only emerge in time.”

Mr. Sedran said he has already taken into account an anticipated slowdown in new mortgage writing in his estimates for major banks’ financial results going forward, and will not adjust them further based on the final rule changes announced Tuesday.

OSFI’s guidelines Tuesday also clarified that borrowers who are renewing existing mortgages will not have to meet the new stress test standard as long as they are staying with the same lending institution. However, renewals done with another lender will have to qualify under the revised standards because they require new underwriting.