Real Estate
Determining Your Mortgage Affordability - Debt Ratios
As a first time homebuyer, it’s very important to know every aspect about your dream home, particularly how much can you afford. It is very unlikely that you are buying it with 100% cash and likely require assistance from a financial institution. Now the question is, how much are they willing to lend to you, generally in the form of a mortgage. While there are certainly tools available that does all the calculation for you, it’s good to understand how lenders calculate the maximum amount they are willing to lend you. Here in this article, we talk about everything you need to know about the basics of debt ratios and how it affects your mortgage affordability.
What Is Mortgage affordability?
Mortgage affordability refers to how much you’re able to borrow, based on your current income, debt, and living expenses. It’s essentially your purchasing power when buying a home. As such, the higher your mortgage affordability, the more expensive a home you can afford to purchase. Remember to borrow within your limits because you’re responsible for paying back the mortgage to your lender, in order to avoid foreclosure. For those who are new to buying a home or just want a detailed explanation on what a mortgage is, we’ve got you covered. You can read it right here.
What are Debt Ratios?
When it comes to underwriting a mortgage, debt ratios are one of the many criteria used to decide lending eligibility. Debt ratios evaluates the borrower’s risk and their ability to repay the mortgage by ensuring your debt (car payments, student loans, credit card bills, etc.) does not exceed a certain percentage of your income. There are two ways for lenders to calculate your debt ratios: gross debt service (GDS) ratio or total debt service (TDS) ratio.
Gross Debt Service (GDS) Ratio
GDS ratio is the percentage of the total sum of your annual housing expenses (mortgage payments, property taxes, heat and half of condominium fees, if applicable) divided by the annual household income. To summarize, GDS ratio is calculated using the following formula.
Gross Debt Service Ratio = Annual Housing Expense / Annual Income
= (Mortgage payments + Property taxes + Heating Costs + 50% of condo fees) / Annual Income
In general, financial institutions have a guideline to lend up to a certain amount where the GDS ratio doesn’t exceed 35%, for CMHC-insured mortgages. Borrowers with good credit scores and a reliable source of income may qualify for larger mortgages and the GDS maximum limit to 39%
Total Debt Service (TDS) Ratio
TDS ratio is the percentage of the total sum of your annual debt payments divided by annual household income. Annual debt payments include housing expenses, credit card interest payments, car payments and other loan expenses (student loans, alimony, child support, etc.). To summarize, TDS ratio is calculated using the following formula.
Total Debt Service Ratio = Annual Debt Payments / Annual Income
= (Housing Expense + Credit Card Interest Payments + Car Payments + Other Loan Expenses) / Annual Income
In general, financial institutions have a guideline to lend up to a certain amount where the TDS ratio doesn’t exceed 42%, for CMHC-insured mortgages. Borrowers with good credit scores and a reliable source of income may qualify for larger mortgages and the TDS maximum limit to 44%
What If My GDS/TDS ratio is above the Guideline?
As stated above, the 35% GDS and 42% TDS limits are guidelines and not set-in-stone rules. If you have a good credit score, a reliable source of income or some valuable assets, you may still qualify for a mortgage, even if your GDS and TDS are slightly higher than the guideline. The maximum limits allowed for GDS and TDS is 39% and 44% respectively. There are also various ways to reduce the GDS/TDS ratio, such as saving up more for your down payment or paying off some existing debt before buying a home. Remember to not stretch yourself too thin financially by buying a home that you might not be able to afford.
What's next?
We advise you to speak to a professional financial lender and get active in determining your mortgage affordability. A little effort now goes a long way.
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