There are many different factors that you will take into consideration when considering purchasing a property, including its location, size, and affordability. The last of these, affordability, is obviously one of the biggest factors that the lender will consider when you decide to take the last step in the purchase of your property and apply for a mortgage. But the way a lender determines affordability and the way you determine affordability are probably very different.
To a lender, affordability translates into two things: Gross Debt Service Ratio (GDS) and Total Debt Service Ratio (TDS). GDS and TDS are two mortgage formulas that lenders use to determine exactly how much money they are willing to lend you. Fortunately, you can make these calculations for yourself before applying for your mortgage so there shouldn’t be any nasty surprises lurking in the numbers. Let’s explore what each of these ratios mean and what the exact mortgage calculation formula is.
Gross Debt Service (GDS)
A GDS ratio is the percentage of your income needed to pay all of your monthly housing costs, including principal, interest, taxes, and heat (PITH). You’ll also need to include 50 per cent of your condo fees, if applicable. The majority of lenders abide by a general standard of 35 per cent, so your GDS should be lower than that to qualify for a mortgage.
To calculate your GDS ratio, you’ll need to add all of your monthly housing-related costs and divide it by your gross monthly income. Then multiply that sum by 100 and you’ll have your GDS ratio.
Total Debt Service (TDS)
Your TDS ratio is the percentage of your income needed to cover all of your debts. The debt ratio formula calculation is the same as that of the GDS, except all of your monthly debts are taken into consideration. This includes car payments, credit cards, alimony, and any loans. The industry standard for a TDS ratio is 42 per cent.
To calculate your TDS ratio, add all of your monthly debts and divide that figure by your gross monthly income. Then multiply that sum by 100 and you’ll have your TDS ratio.
Alternatively for both GDS and TDS calculations, you could add up your monthly housing expenses/all of your monthly debts and multiply by 12 to get the total amount for the year, and then divide that number by your annual salary. Multiply that figure by 100 to get your GDS/TDS ratio.
Let’s look at some scenarios:
- Linda and Bill want to buy a house. Their combined annual salary is 82,000, which makes their gross monthly income $6,833. They estimate that their mortgage payment and property taxes will be $2,250, heat will be $75, and they’re making $250 in credit card payments a month, with $375 in car loans.
TDS: $2,950 / $6,833 = .43 x 100 = 43 per cent
- Ed wants to buy a condominium. With an annual salary of $65,000, his gross monthly income is $5,417. He estimates that the mortgage payment on his home will be $1,650, his monthly bill for his property taxes will be $125, heat is $35, and condo fees are $500. He also has a student loan payment of $550.
TDS: $2,610 / $5,417 = .48 x 100 = 48 per cent
As you can see, Linda and Bill are below the GDS standard, but their TDS is a little bit higher than lenders like to see. Both of Ed’s ratios are too high according to industry standards.
What if my ratios are higher than the industry standard?
The first thing to remember is that these ratio percentages are simply industry guidelines and vary from lender to lender, both within the same category of lender as well as across different types of lenders (banks vs. non-depository lenders, B lenders and private lenders). Therefore, they are not set in stone. Some lenders will emphasize other factors when determining the validity of an applicant. For instance, the loan-to-value ratio (LTV) is much more important to B lenders, as they are lending based on equity and income can simply be stated to alter the TDS/GDS ratios. The LTV is a simpler calculation; it’s the ratio of the size of the loan to the value of the property.
In some cases, the loan may be high-ratio (which means that the down payment for that loan was less than 20 per cent), which requires it to be insured by the Canadian Mortgage and Housing Corporation (CMHC) or by private insurers Genworth or Canada Guaranty. In the case of insured loans, the GDS or TDS can be as high as 39 to 44 per cent with a credit score of at least 680.
In the two scenarios above, Bill and Linda can lower their TDS by eliminating their credit card debt, while Ed could benefit from choosing building with less expensive condo fees, which would lower both of his GDS and TDS ratios. But while Bill and Linda have lower GDS and TDS ratios, if they also have a lower credit score, then they still may not be viewed as favourably as their ratios suggest. Conversely, while both of Ed’s ratios are higher than the standard, other factors may consider him less of a risk.
According to the CMHC, it’s important to note that “debt service flexibilities are based on an assessment of the strength of the overall application. Satisfying the minimum credit score alone does not automatically entitle the borrower to debt service flexibilities.” The easiest and simplest ways to decrease your ratios are paying off some of your debt load, increasing your down payment, or adding rental income. If you will be living with a partner and don’t have them added to the application for some reason, then consider doing so if it will add income to the equation. Depending on the amount of debt that your partner is carrying, it may not be helpful, but it’s certainly worth doing the calculation to check. Another option (that many people don’t like to confront) is to buy a less expensive home, whether that means one with a lower sales price, lower operating/heating costs, or lower property taxes in a different area.
GDS and TDS ratios are just a small component when looking at your overall suitability as a borrower, but it gives lenders a way to figure out whether or not your income will cover the costs of your mortgage, and therefore be less of a risk to the lender. Still, if your GDS and TDS ratios are higher than the industry standard, it’s worth trying to tackle some of your debts before seeking out an alternative lender, since those lenders will often have higher interest rates as well as higher fees associated with the loans. Remember, the lenders aren’t looking at you personally and judging whether or not you deserve a home; they’re looking at you as a potential risk and calculating whether or not they’re going to be able to collect the money that you’ll owe them.
Your GDS and TDS figures don’t tell the whole story – they don’t take other basic expenses into account like transportation or food. So you want the ratios to be as low as possible to leave room for all of your other incidentals. Using an affordability calendar to figure out how much mortgage you can actually afford will help you keep an eye on the bigger picture.