What is a debt service ratio?
For the vast majority of Canadians, a mortgage is the most significant debt they will take on in their lifetimes.
When you buy a new home, you agree to pay back a large amount of money, usually over a prolonged period of time.
For lenders, mortgages are a substantial layout, so it makes sense to do some research and homework before approving an application.
One of the metrics used by lenders to assess viability for a loan is debt service ratios.
As the federal government has taken steps to tighten regulation in recent years, it has never been more important to work towards a healthy debt service ratio.
There are two debt service ratios used by lenders to assess and evaluate mortgage applications.
These are:
- GDS: gross debt service ratio.
- TDS: total debt service ratio.
Gross debt service ratio
The GDS ratio is a measure of how your income stacks up against your outgoings.
A lender will use the GDS ratio to compare your take-home pay with your household expenses, which include:
- Your mortgage repayment.
- Property taxes.
- Heating bills.
- 50% of your condo fees.
Unlike a credit score, with the GDS ratio, you’re not looking for a high numbe
Ideally, you should aim for a GDS ratio of less than 32.
A GDS ratio of 32 or below indicates that you can afford to take out the mortgage and pay it back.
If your score is higher, this represents a greater risk for the lender, and the chances of approval will be lower.
How is the GDS ratio calculated?
The GDS ratio is calculated using a set formula, which is utilised by lenders across Canada.
This formula is:
GDS= (PITH + ½ condo fees) / monthly take-home pay x 100
In this equation, P= mortgage principal, I= mortgage interest, T= property taxes and H=heating.
If your mortgage payment is $1,450 per month, your property tax charge is $250, you spend $110 on heating and your monthly income is $6,000, this will equate to a GDS ratio of 30.17.
This figure is below the industry standard and your application should be approved.
TDS (Total Debt Service) ratio
The TDS (total debt service) ratio represents a more complex calculation, as it takes your debt repayments into account.
The TDS ratio covers everything in the GDS, but it also includes your monthly debt repayment.
This includes credit cards, car finance, student loans and other lines of credit.
To calculate your TDS ratio, mortgage lenders use the following formula:
TDS= (PITH + ½ condo fees + monthly debt payments) / monthly take-home pay x 100
If you used the same figures as the GDS ratio and added a monthly debt payment of $500, the TDS ratio would be 38.5%.
The industry standard TDS ratio is 40%.
Why your debt service ratios matter
For many people, buying a home is a huge step, as it represents a long-term financial investment and the opportunity to put down roots.
If you’re desperate to get onto the property ladder, or to climb up it, it’s important to give yourself the best chance of getting a mortgage application approved.
Your debt service ratios form an integral part of the evaluation process, as they provide an insight into the level of risk you pose.
Lenders are more willing to approve loans for those who have ratios that are below the industry standard.
In recent years, the government has made the process more stringent and restrictive to reduce the risk of people taking out mortgages they cannot afford to repay, so it’s crucial to understand the importance of your debt service ratios.
The average Canadian household currently owes $1.78 for every $1 earned, with 14.9% of household income going towards paying off debt.
Ways to improve your debt service ratios
If you’re thinking about applying for a mortgage, it’s useful to view your debt service ratios as a scoring system.
Unlike your credit rating, you don’t want to increase your score.
Instead, you want to try and bring the figure down so that the lender views you as a low-risk applicant.
If your debt services ratios are higher than the industry standard, you will be deemed higher risk, and your application may be rejected.
To improve the debt service ratio, there are 3 things you can do.
These include:
- Look for opportunities to transfer credit card balances from high-interest accounts to low-interest or interest-free cards. According to TransUnion, the average credit card balance is expected to rise to $4,465 by the end of 2020. Reducing interest payments could save you hundreds of dollars per year.
- Avoid taking on additional debts: if you’re trying to apply for a mortgage, and your debt service ratio is too high, try and avoid borrowing more money or opening up lines of credit.
- Use spare income to pay off debts: if you have money left over after you’ve covered your monthly outgoings, try and clear as much debt as possible. This will reduce the total amount of debt you owe, lower interest payments and improve your credit score and your debt service ratios.
You can also increase your chances of getting a mortgage by saving as much as possible to increase your down payment value.
The more you can put down initially, the less you’ll need to borrow from a lender.
Conclusion
Debt service ratios are used to assess mortgage applications.
If your score is lower than the industry standard, you stand a good chance of having your mortgage approved.
If your ratio is too high, don’t panic.
There are ways to bring the figures down and improve your score.
If you have any queries, or you’d like to speak to an advisor, don’t hesitate to get in touch.
Our friendly team is here to help.
