How banks ascertain your affordability
A recent study by CIBC indicated that nearly half of all mortgages in Canada (47%) are due for renewal during 2018. (Original source) Making decisions about the best mortgage option is in the minds of millions of homeowners now more than ever.
When shopping around for a mortgage, there’s more to think about than simply finding the best mortgage rates. It’s important to also consider the terms and conditions of your mortgage, the size of your down payment, and whether or not you can afford the home—and monthly mortgage payments—you’re thinking about.
The ways a lender determines affordability and the way you determine affordability are probably very different. That’s why it’s a good idea to understand how lenders calculate your affordability and the formulas they use to do so. This is to ensure that you are not in for any nasty surprises.
Gross Debt Service Ratio (GDS) and Total Debt Service Ratio (TDS) are two mortgage formulas that lenders use to determine exactly how much money they are willing to lend you. Fortunately, you can make these calculations for yourself before applying for your mortgage.
Let’s explore what each of these ratios means and what the exact mortgage calculation formula is.
GDS (Gross Debt Service Ratio)
The GDS ratio is the percentage of your income needed to pay all of your monthly housing costs, including principal, interest, taxes, and heat (PITH)., and additionally, 50 percent of your condo fees, if applicable. The majority of lenders abide by a general standard of 35 percent, so your GDS should be lower than that to qualify for a mortgage.
To calculate your GDS ratio, you’ll need to add all of your monthly housing-related costs and divide it by your gross monthly income. Then multiply that sum by 100 and you’ll have your GDS ratio.
TDS (Total Debt Service Ratio)
Your TDS ratio is the percentage of your income needed to cover all of your debts. The TDS calculation is the same as that of the GDS, except all of your monthly debts are taken into consideration. This includes car payments, credit cards, monthly payments, and any loans. The industry standard for a TDS ratio is 42 percent.
To calculate your TDS ratio, add all of your monthly debts and divide that figure by your gross monthly income. Then multiply that sum by 100 and you’ll have your TDS ratio.
Lucy and William want to buy a house. Their combined annual salary is 82,000, which makes their gross monthly income $6,833. They estimate that their mortgage payment and property taxes will be $2,100, heat will be $75, and they’re making $250 in credit card payments a month, with $375 in car loans.
GDS: $2,175 / $6,833 = .31 x 100 = 31 per cent
TDS: $2,800 / $6,833 = .41 x 100 = 41 per cent
As you can see, Lucy and William are below the GDS and TDS standard. They are prime candidates for lenders to qualify for a mortgage.
What if my ratios are higher than the industry standard?
The first thing to remember is that these ratio percentages are simply industry guidelines and vary from lender to lender, both within the same category of lenders as well as across different types of lenders (banks vs. non-depository lenders, B-lenders(unregulated lenders) and private lenders.
Therefore, they are not set in stone. Some lenders will emphasize other factors when determining the validity of an applicant.
John wants to buy a condominium. With an annual salary of $65,000, his gross monthly income is $5,417. He estimates that the mortgage payment on his home will be $1,650, his monthly bill for his property taxes will be $125, heat is $35, and condo fees are $500. He also has a student loan payment of $550.
GDS: $2,060 / $5,417 = .38 x 100 = 38 per cent
TDS: $2,610 / $5,417 = .48 x 100 = 48 per cent
As you can see, Both of John’s ratios are too high according to industry standards. Ed could benefit from choosing a building with a less expensive condo, lesser condo fee, which would lower both of his GDS and TDS ratios. He could also try to eliminate his credit card debt to boot.
The easiest and simplest ways to decrease your ratios are paying off some of your debt load, increasing your down payment, or adding rental income. If you will be living with a partner and don’t have them added to the application for some reason, then consider doing so if it will add income to the equation.
In some cases, where the down payment for that loan was less than 20 per cent, which requires it to be insured by the Canadian Mortgage and Housing Corporation (CMHC) or by private insurers , the GDS or TDS can be as high as 39 to 44 per cent with a credit score of at least 680. According to the CMHC, it’s important to note that “debt service flexibilities are based on an assessment of the strength of the overall application. Satisfying the minimum credit score alone does not automatically entitle the borrower to debt service flexibilities.”
Another option which was mentioned in John’s example (that many people don’t like to confront) is to buy a less expensive home, whether that means one with a lower sales price, lower operating/heating costs, or lower property taxes in a different area.
GDS and TDS ratios are just a small component when looking at your overall suitability as a borrower, but it gives lenders a way to figure out whether or not your income will cover the costs of your mortgage. Also, they don’t tell the whole story – they don’t take other basic expenses into account like transportation or food. So you want the ratios to be as low as possible to leave room for all of your other incidentals.
Are you still looking for more information on mortgages and your affordability? ReVa can tell you exactly how much you can afford to borrow and which is the best mortgage for you. She will also match you with the best listings based on your personal preferences and financial capabilities. Click here to Just Ask ReVa.
Additionally, you can download our free step by step guide for homeowners designed to equip and empower first time home buyers with all the knowledge they will need to make this huge lifetime investment.