When determining how much you can afford when buying a home, lenders will look at two significant factors: your gross debt service (GDS) ratio and your total debt service (TDS) ratio. While these two ratios are simple calculations, understanding how they work could help you afford a home.
Your gross debt service ratio is the amount you’re spending on housing relative to what your pre-tax income is. The expenses used for the calculation include:
Generally speaking, lenders don’t want your GDS ratio to exceed 32% of your income.
Your total debt service ratio is similar to your GDS ratio, but it adds any other debt that you may have, including:
In most cases, lenders set a limit of 40% for your TDS ratio. That said, it’s possible to exceed the TDS and GDS ratio limits if you’re purchasing a home as a couple. This is possible since lenders look at the combined income and debts when determining mortgage affordability.
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Since you know how the gross debt service and total debt service ratios work, let’s see how they apply to a real-life scenario.
Let’s say John and Mary have a combined income of $120,000 a year before taxes ($10,000 a month). They’re looking to purchase a home and have estimated their monthly housing costs to be as follows:
That’s a total of $3,060 that they’ll spend on housing costs each month. If they divide that number by their monthly pre-tax income of $10,000, it works out to 30.6%. That’s below the lender’s GDS ratio limit. That means the house they’re looking at is affordable.
Now, let’s see how their total debt service ratio affects things. Let’s assume that John and Mary also have the following monthly debt payments:
That’s an additional $1,050 in monthly expenses, which puts them at a total of $4,110. When you divide that by their monthly income, their TDS is 41.1%, exceeding the lender’s criteria of 40%.
In other words, they can’t afford the home they’re looking at.
Even though your GDS and TDS ratios are simple calculations, there are a few things that could affect both ratios. These curveballs could affect your affordability and need to be factored in when buying a home.
When people budget for a home, they will usually use the interest rate provided by their lender during the mortgage pre-approval process.
However, the federal government has a mortgage stress test that requires you to qualify at 2% above your lender’s mortgage rate or 5.25%, whichever is higher. What that means is your mortgage application is tested at a higher mortgage rate, so your monthly mortgage costs appear higher on paper. That increases your GDS and TDS ratios.
Anyone who’s purchasing a home that costs less than $1 million with a down payment of less than 20% will require mortgage loan insurance for their high-ratio mortgage. This added insurance is meant to protect lenders if you default. Since there’s an added cost for this insurance, CMHC factors that in and allows you to have a GDS ratio of 35% and a TDS ratio of 42%. This gives house hunters who require mortgage loan insurance a little bit of flexibility.
It’s important to understand that the GDS and TDS ratios are typically guidelines and not hard rules. If you speak to your financial institution or mortgage broker, they may have a solution to help you.
Alternatively, you could try one of the following things:
Having low debt service ratios tells lenders that you can reasonably afford a home. While this number isn’t foolproof, it’s a good estimate for everyone involved. Stay under the recommended ratio limits, and you likely won’t have any issues paying your mortgage.
Barry Choi is a personal finance and travel expert. His website moneywehave.com is one of Canada's most trusted sites when it comes to all things related to money and travel. You can reach him on Twitter: @barrychoi.