When I first started in this business, my Mother asked me if we still based mortgage qualification on the calculation of two and a half times a person’s yearly salary. “Mooooom!”, I said, rolling my eyes. “ That’s the calculation for an engagement ring now a days! Geez -you can park your covered wagon over there!”.
Actually, I would never say that to my Mom. I let her park her wagon where ever she wants. Most people do. And the two and half month’s salary thing is a typical rule of thumb in the States, although I believe it’s up to three or fours times your annual salary now.
So how does a lender in Canada decide how much of a mortgage you can comfortably afford? Along with examining your credit, they actually begin with looking at two calculations – a Gross Debt Servicing Ratio (GDS) and a Total Debt Servicing Ratio ( TDS) . But what does it all mean and how does it keep you safely within your means when the Finance Minister is busy issuing warnings that Canadians should be careful not to take on too much debt in the coming years?
Let’s take a look at GROSS Debt Servicing. GDS is the percentage of gross annual income required to cover payments associated with HOUSING only. Monthly housing payments include your mortgage payment ( principle + interest), CMHC premiums, property taxes, heat expense, and if applicable secondary financing, condo fees ( 50%), or lot rental fees.
For this calculation, the lender will add together the potential monthly housing expenses applicable to your situation, multiply it by 100 and then divide that total by your gross monthly household income.
GDS = Total monthly payments (x 100) __________________________
Gross monthly income
GDS is used in the First Affordability Rule. According to CMHC, the rule is that your monthly housing costs shouldn’t be more than 32% of your gross, household monthly income. Most lenders feel this is an acceptable portion of income to be allotted to your total housing costs and anything exceeding 32% may cause the average person undo pressure in meeting these expenses. There are exceptions to the rule but we will get to that shortly.
TOTAL Debt Servicing is the percentage of gross annual income required to cover payments associated with housing AND all your other debts, such as car loans and credit cards. The lender takes your housing expense total from your GDS calculation, adds to it the rest of your monthly debt payments and multiplies it by 100. This value is then divided by your gross monthly household income to arrive at your TDS ratio.
TDS = Total monthly payments (x 100) ___________________________
Gross monthly income
Again, according to CMHC, the second affordability rule is that your ENTIRE monthly debt load shouldn’t be more than 40% of your gross monthly income, anything more than that may put you in a situation that may require more income than is comfortable going towards paying debt. When that happens, your ability to afford living expenses such as food, utilities and transportation costs is jeopardized.
Lenders know that when tough times hit, the average person is more likely to spend a limited income on feeding their family rather than making a debt payment, it’s only natural. They want to make sure from the get-go that their is plenty of room in your monthly budget to manage all of your payments so you don’t have to choose between groceries and your mortgage.
Earlier, I mentioned there are exceptions to these basic rules of qualification. Some lenders will extend the base ratios of 32/40 when an applicant’s credit score is above average, if they are offering a product that does not require CMHC insurance or if lending is based primarily on the value of the property as apposed to the borrowers ability to repay the loan which is typical of sub prime lending. And let’s face it – lenders are in the business of lending money, so while they want to be reasonably sure you can repay the loan, they are also going to approve you for the MAXIMUM amount you can afford to increase their own business. It’s up to you to decide what kind of a payment you can comfortably afford each month and be able to save for those rainy days that we all experience.
At First Foundation, we want to give you the very best start with your mortgage and we will assist you in taking a realistic look at what you can afford when considering the purchase or refinance of a home. We know that a true dream home is not just the one that you can qualify for but the one you can afford to heat, eat a nice dinner in and leave to go on vacation once and a while.
Check out our mortgage calculators and be sure to give our Mortgage Brokers a call to talk about your results!