Home buyers need to understand the maximum mortgage they qualify for and how that impacts the price they are able to pay for a home
Maximum Affordability
Homebuyers need to understand the maximum mortgage they qualify for and how that impacts the price they are able to pay for a home. This is called maximum affordability. To figure out what your maximum affordability is there are a number of factors that need to be considered. These include:
Any down payment you’ll be making
What your debt service ratios are. This is the ratio between your income, and monthly expenses of home ownership and monthly debt payments you are making.
How down payment impacts affordability
A down payment on a property must be at least 5% of the purchase price, which is why how much you have for a down payment directly relates to your affordability. For example, if you would otherwise qualify for a $400,000 mortgage, but you have $15,000 for a down payment, you would have 5% of a $300,000 purchase price. In this example, your down payment will be one factor that contains, or limits, your maximum affordability. On the other hand, if you qualify for maximum $300,000 mortgage based on your debt service ratios and the monthly payments, but you have a total of $50,000 you can use towards down payment, your affordability increases dollar for dollar with that extra down payment money. In that example, you could purchase up to $350,000.
How debt service ratios impact affordability
Debt service ratios are one of the factors that demonstrates your ability to pay for a home. The guidelines for these ratios are generally set by the Canada Mortgage and Housing Corporation (CMHC) for insured mortgages. Specific lending criteria may increase or decrease the maximum debt service ratios allowable on a particular application. Your debt service ratios will be used by a lender to determine the maximum amount you can afford to pay for a home.
All these ratios are used to help work out what you can reasonably afford to pay each month. There is a limit on how much of your income can be directed to housing expenses and how much goes toward your debt. As a guideline, GDS should not be higher than 35% and TDS should not exceed 42%. It is important to note that if you have a steady income and good credit rating you may be permitted to go over these limits. For the most part, if you are looking at a home that would put your GDS over 39% or your TDS over 44% you are unlikely to be approved for a mortgage.
This is how your GDS and TDS scores may limit the amount you can borrow: even if you have $20,000 for a down payment, your ratios may mean you can only qualify for a $250,000 mortgage. In this case, your maximum affordability would be $270,000.
Tips for increasing your affordability
Some home buyers may find this frustrating, particularly if they already have their hearts set on a new home that is seen as too expensive. Increasing your maximum affordability can be done. Here are a few steps you can take:
Make a bigger down payment
Increasing the amount you put forward as a down payment can push up your affordability. This means you may be able to buy a home at a higher price point than you initially thought.
Pay off debt
The less debt you have the lower your TDS ratio will be, which means you will have more monthly income to put towards your mortgage payments. This move can help you qualify for a bigger mortgage and a more expensive home.
Bump up your earnings
Simply put, if you earn more, you can afford more. Although it is not easy, finding a way to bring in more money each month can help you get a bigger mortgage. Another way to improve how your income looks on paper is to apply with a partner or co-signer.
Smart home ownership
It is important to keep in mind that your GDS and TDS ratios are only guides. When it comes to purchasing a home, you don’t have to aim for the maximum amount you qualify for. For the most part, how much you spend on your home is up to you, so make sure that you don’t stretch yourself too thin.
Example of Maximum Affordability
To help you understand the concept of maximum affordability better, let’s look at a possible calculation.
Say your annual gross income is $60,000
The property taxes on the home you want are $2,400 per year, plus heating costs will be about $100 per month.
Over and above your housing costs, you have a monthly car payment of $300
You have $10,000 of credit card debt
You have been able to save up $25,000 for a down payment.
Calculate Income
Your monthly income before tax is $5,000 ($60,000 divided by 12). Using the base guidelines of 35% for GDS (mortgage, property taxes, 50% of condo fees if any, and heat) and 42% for TDS (housing expenses plus other debt payments) you could afford a total monthly housing payment of $5,000 x 35% = $1,750, and can use up to 42%, or $2,100, towards housing expenses plus other debt payments.
$60,000 ÷ 12 = $5,000 per month gross income $5,000 x 35% = max $1,750 per month for housing expenses $5,000 x 42% = max $2,100 per month for housing expenses and debt servicing
Calculate Property Expenses and Max Mortgage Payment
In this example, you could afford a mortgage payment of $1,750 minus the $200/month for property taxes, and $100/month for heat, leaving $1,300 that can be used for the mortgage payment.
$1,750 - $200 (property taxes) - $100 (heat) = $1,450 max mortgage payment $1,450 per month equates to a total mortgage amount of $245,000, using the stress-test rate of 5.19% (current as of August 12, 2019) and a 25 year amortization. This amount will change based on changes to the stress-test rate.
Include debt servicing payments
When we include the $300/month car payment, and $10,000 of credit card debt (which translates to a $300/month debt servicing payment equal to 3% of the balance) we end up with $600/month of additional liability payments.
$1,750 per month for housing expenses, plus $300 per month loan payment, plus $300 per month debt servicing on credit card debt, equals $2,350 per month
If we add the $1,750 for housing expenses and the $600 for liability payments, a total of $2,350, we are over-limit on the Total Debt Servicing ratio. You would need to reduce your monthly debt servicing payments by $250 per month ($2,350 minus $2,100) by either paying off the car loan, or paying off (or majorly paying down) the credit card debt. You could also reduce the housing expenses by $300/month by buying a less expensive property.
If you paid off the credit card debt using $10,000 of the $25,000 you have saved up for your down payment, the new maximum affordability would look like this:
$1,750 per month for housing expenses, plus $300 per month loan payment, plus $0 per month debt servicing on credit card debt, equals $2,050 per month
In the above example, you would now qualify and stay within your maximum affordability.