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Mortgage Calculators
A Guide to Debt Service Ratio
When you start the process of home buying, it is best practice to ensure that you know what is going on in the entire process. Many things go on behind the scenes with securing a mortgage, and one of the extensive calculations is, in fact, your debt service ratio. Unlike your affordability calculator, your debt service coverage ratio is the actual calculation that a lender will complete during your mortgage approval. Lenders do two specific calculations to figure out your debt service ratio. The first is your debt service ratio, and the second is your total debt service ratio.
Although they sound similar, the calculation is slightly different and provide your lender with a risk portfolio to either approve or deny your mortgage. Let us dive into a little more detail about these processes that go on behind the scene when applying for a mortgage loan in Canada.
What is debt to service ratio?
A debt to service ratio is a financial term looking at the overall income coming in for an individual or company to the overall debt that they are still paying off. This term is used in corporate finance, personal finance and even government finance. The calculations are pretty simple. Your debt to service ratio is your net operating income divided by your total debt service. To put it in a more friendly way, your debt service ratio is your income, and any additional income streams divided by your current debt load. Debt could include car payments, student loan payments, credit card payments and even child support or alimony. This calculation helps a lender determine if your specific situation is the right risk portfolio for a mortgage. The higher your ratio, the riskier it is for a lender to provide you with a mortgage loan to buy a home. How do you even calculate your debt service ratio, and what can you do to help lower the ratio if it is too high?
How do you calculate debt service coverage ratio?
You can use this handy calculation to run the numbers on your debt service ratio. As we noted above, the debt service ratio is split into two separate calculations. Your gross debt service ratio and your total debt service ratio. Here is how to calculate both:
Gross Debt Service Ratio
You will take your mortgage payment (or estimated mortgage payment based on our mortgage affordability calculator), your property taxes, your heating costs, and 50% of your condo fees if applicable. If you are not positive on the numbers, you can use approximations. You will then take all of those debts and divide the sum by your annual household income. The result will be your gross debt service ratio. Ideally, this number should be less than 32%.
GDS= (Mortgage payment + property tax + heating costs + 50% of condo fees) / annual income
Total Debt Service Ratio
To calculate the total debt service ratio, you will take your housing expenses calculated for your GDS and add any credit card interest you are paying, car payments, loan expenses, and any other debt payments. This sum is then divided by your annual household income; the resulting number is your TDS. Your TDS should ideally be under 40%.
TDS = (Housing expenses, as calculated in your GDS, + credit card interest + car payments + loan expenses + any other debt payments) / annual income
What is included in debt service ratio?
Gross Debt Service Ratio (GDS)
- The annual income of the buyer or buyers of the property. This should include your current job and any side hustles or income you generate outside of your 9-5
- Monthly mortgage payment
- Property Taxes
- Monthly heating costs
- Condo fees
Total Debt Service Ratio (TDS)
All of your current housing costs plus the monthly totals for the following:
- Credit card interest
- Student loan payments
- Line of credit payments
- Child support or Alimony payments
- CRA payments
- Any outstanding loans
What is Total Debt Service (TDS) and Gross Debt Service (GDS)?
The GDS ratio is the calculation that the lender will use to see how much housing costs you will be paying compared to your annual income. The cardinal rule in personal finance is your housing costs should not exceed 30%, but for the GDS, you can actually exceed that as the maximum industry standard is 32%. These housing costs include any mortgage payments, condo fees, property taxes and heating costs.
The TDS ratio is the calculation that the lender will use to see how much your total debt, including your housing costs, will be compared to your annual income. Essentially, the calculation considers any debt services you are paying off and what your actual monthly expenses are when you add on housing costs. For a borrower to afford the mortgage they want, this number should be less than 40% per the industry standard.
Maximum Limits
As you may suspect, each lender will have its in-house maximum limit not released to the public. The guidelines that we have seen are the GDS to be no more than 32% and the TDS to be no more than 40%. However, borrowers who have good credit and a reliable income may be able to secure a mortgage with a higher ratio, but it depends on the specific lender.
The absolute maximum limit allowed by any lender in Canada is 39% GDS and 44% TDS.
For those who will be purchasing mortgage default insurance, the CMHC implemented a few changes you should be aware of on] July 1, 2020. As of this date, all borrowers with CMHC insurance can only have a maximum of 35% GDS and 42% TDS. However, the other two mortgage default insurance providers did not follow suit. Due to this, lenders now can either use CMHC maximum amounts or the different non-released maximums from the other providers to approve a mortgage loan.
Tricks to help avoid a high debt service ratio
There are a few ways to help secure a ratio mortgage while still making sure your lenders are happy with your debt obligations. Here are a few ways that can help you get that mortgage!
1. Avoid securing a car loan before your mortgage
For many young people, a car is the first step to freedom. However, in lenders’ eyes, a car loan means debt, which could affect the formula used to secure your mortgage. If at all possible, avoid the car loan until after you confirm your mortgage.
2. Repay any outstanding debt
When it comes to important things like trying to qualify for a mortgage, the amount of debt you have does matter. Everything adds up, and when it comes to the various ratios formula, every debt does count. So, before you secure your mortgage, look to pay down any outstanding principal and interest debt and attempt to repay lines of credit, for example.
3. Increase your annual income
Increasing your annual income is a little easier said than done, but a raise in your yearly pay will naturally help alleviate many ratio problems. You can do this by starting a side hustle or even looking for your next promotion. Plus, if you can secure a more stable job such as government or banking, the lender’s ratios will adjust.