How Existing Debts Can Reduce The Amount Of Mortgage You Can Get Approved For
The Impact of Debt on Mortgage Approval
When applying for a mortgage, lenders consider your debt levels. High debt levels can lower the mortgage amount you’re approved for, or even result in a declined application. This is because lenders assess your ability to manage and repay the mortgage alongside your existing debts.
Understanding The Debt Service Ratios
Lenders use two key ratios to determine your eligibility for a mortgage: the Gross Debt Service ratio (GDS) and the Total Debt Service ratio (TDS). These ratios measure the proportion of your income that is spent on housing costs and total debt payments, respectively.
Mortgage Qualifying Ratios: GDS and TDS
There are two ways to calculate how much the qualifying amount is, and they are calculated by the above mentioned mortgage qualifying ratios, GDS and TDS. The GDS is capped at 39% of annual income, and the TDS at 44% of annual income, for borrowers with good overall credit, and higher credit scores. Lower credit scores might result in lower GDS/TDS ratios which will lower the qualifying amount. The GDS only covers the housing costs, and the TDS will include any additional debt repayment.
A Practical Example
Consider a family with an annual income of $120,000, and good credit, applying for a mortgage at the rate of 5.24%, and a property with a tax of $4,200 per year. They have no credit card debt, loans or other debt. If we calculate it at 25-year amortization, and use $100 per month for heating, they would qualify for a mortgage of approximately $482,317.
Flexibility in Additional Debt Payments
In this scenario, we have a flexibility of using approximately $500 per month in additional debt payments and still stay within the 44% TDS.
Impact of Additional Debt Payments
If the additional debt payments were higher, then the TDS will increase, and the qualifying mortgage amount will decrease. For example, $800 additional monthly debt payment will reduce the mortgage amount to approximately $440,377; $1,000 monthly debt will result in a mortgage of $412,416; $1,500 monthly debt will reduce the mortgage amount to $342,515, and so on.
Lender’s Criteria for Payment Qualification
Lenders don’t necessarily use the actual payments that you may have on your debts, or the required minimum amount as per your credit card statement. There are some slight variances from lender to lender, but the following is the more common way that these debts are calculated:
– Credit cards/other revolving debt: at 3% of the outstanding balance.
– Instalment Loans: Payment amount that shows on the credit bureau.
– Student Loan/Line of Credit: Payment on credit bureau if reporting or 3% of balance, if not in repayment.
– Secured Line of Credits: Balance amortized over 25 years against the Bank of Canada’s conventional five-year fixed posted rate.
As you can see these amounts can be higher than the actual amounts.
The Effect of Debts on Mortgage Approval Amount
So, if your credit cards, student loans, car payments and other payments added up to $1,500 per month, the original approval amount from our example will be reduced from $482,317 to $342,515. That is almost $140,000 less than the original amount where the borrowers had no other debts.
Increasing Down Payment vs Reducing Debts
The obvious question that arises is whether we should increase the down payment or reduce the debts. The simplest answer is that everyone’s situation is different. Each situation needs to be analyzed separately, taking into account how much you have available for a down payment, the purchase price, and other factors. Essentially, we need to crunch the numbers and determine which ratios you qualify under.
Let’s look at some examples based on the example from above:
- $750,000 purchase price, and maximum approval amount of $482,317. Down payment required is the difference in the two amounts, or $267,683. The monthly mortgage payment will be approximately $2,871.44, and the only other calculable expenses are the property tax of $350 per month ($4,200/12 months), and the heat of $100 per month. If this was a condo, we will also use half of the condo payment in this calculation. In that case, the approval amount would be lower.
- $600,000 purchase price, and maximum approval amount still the same $482,317. Down payment required is the difference in the two numbers, or $117,683. The monthly mortgage payment will still be approximately $2,871.44, and we still have a property tax expense, but possibly lower due to the lower property value, and the heat of $100 per month. If this was a condo, we will also use half of the condo payment in this calculation. With this scenario, due to the lower purchase price, we can use the difference in down payment to pay down some or all debt, if there was any.
- $500,000 purchase price, and maximum approval amount of $475,000. Down payment required in this case would be 5% of the purchase price. The monthly mortgage payment will be approximately $2,827.88, and we still have a property tax expense, but possibly lower due to the lower property value, and the heat of $100 per month. If this was a condo, we will also use half of the condo payment in this calculation. Same this as with the $600k purchase example, we can use the difference in down payment towards other debt.
- $400,000 purchase price. In this case, the purchase price is less than the maximum approval amount based on the income scenario used. The approval amount will be 95% of $400,000 or $380,000. The monthly mortgage payment will be approximately $2,262.30, and we still have a property tax expense, but possibly lower due to the lower property value, and the heat of $100 per month. If this was a condo, we will also use half of the condo payment in this calculation. With this scenario, due to the vastly lower mortgage amount, we can have additional payment of over $1,000 per month and still qualify for the mortgage.
One thing that is important to mention about the example with the purchase price of $750,000 mentioned above, is that the down payment doesn’t have to be as high as in the example shown. If the borrowers incomes were higher, and they qualified for a larger mortgage, the down payment could be as low as $50,000 on a $750,000 purchase. The way this is calculated is the required 5% on the first $500,000 (500,000 @ 5% = $25,000), and additional 10% on the difference from $500,000 to $750,000 (750,000-500,000 = 250,000 @ 10% = $25,000).
Strategies to Improve Mortgage Approval Amount
Reducing your debt levels can improve your GDS and TDS ratios and your credit score. This can increase the mortgage amount you’re approved for. Strategies include paying down debts, avoiding taking on new debt, and improving money management skills.
In conclusion, it’s crucial to understand the impact of debts on your mortgage approval amount in order to make informed financial decisions. If you’re thinking about applying for a mortgage, it’s important to evaluate your current debt levels and consider their potential impact on your application. Understanding the impact of debt on mortgage approval and taking steps to reduce your debt can improve your chances of being approved for a larger mortgage amount.
Remember, every financial situation is unique, and what worked for one person may not work for you.
If you need more personalized advice, don’t hesitate to reach out to a mortgage professional. At TheBroker.ca Ltd., we’re here to help guide you through the mortgage application process. Contact us today at (519) 252-9665 to start your journey towards homeownership.
Note: The above calculations are estimates, and the information is provided for sample purposes only. Each situation is different, and the actual amounts could vary based on various factors such as interest rates, qualifying rate, term length, credit history, and specific lender criteria. TheBroker.ca Ltd. does not guarantee its accuracy. Information should be verified and should not be relied upon as legal, financial, or other advice.