If you dream of being a homeowner one day, it’s important to understand how to calculate debt service ratios. With home prices sky-rocketing in major cities across Canada, paying for your home with savings is no longer possible for most homebuyers.
A mortgage can help make your dreams of homeownership a reality a lot sooner. Banks use debt service ratios when reviewing your mortgage application. Good debt service ratios can mean the difference between your mortgage application being tossed in the approved or rejected pile.
Gross Debt Service (GDS) Ratio
The Gross Debt Service (GDS) ratio looks at the percentage of your gross monthly income required to cover your monthly home expenses. Home expenses include your monthly mortgage payment, property taxes, heating bill, and if you live in a condo, 50 per cent of condo fees. You should aim for a GDS ratio below 32 per cent. If you have a high credit score, banks are often willing to waive the GDS requirement.
How to Calculate the GDS Ratio
As a future homeowner, it’s important to understand how to calculate the GDS ratio. To calculate your GDS ratio, use your bank statement to add up your monthly home expenses (your monthly mortgage payment, property taxes, heating bill, and condo fees). Once you have the total, divide it by your gross monthly income (you can find that on your pay cheque) and multiply by 100 and voila, you have your GDS ratio!
GDS Ratio Formula:
GDS = (PITH + ½ Condo Fees)/Gross Monthly Income x 100
P = Mortgage Principal
I = Mortgage Interest
T = Property Taxes
H = Heating
Let’s go through an example to let you wrap your mind around this ratio. If you have a monthly mortgage payment of $1,280, property taxes of $240, monthly heating bill of $110 and gross monthly income of $5,900, your GDS will be:
GDS = ($1,280 + $240 + $110) / $5,900 x 100 = 27.63%
The good news is your GDS is below the recommended 32 per cent. As long as you budget properly, you shouldn’t have any issue paying for your property on a monthly basis.
Total Debt Service (TDS) Ratio
Now that you know how to calculate the GDS ratio, let’s take it a step further and introduce you to the TDS ratio. The TDS ratio is a lot like the GDS ratio. It still includes your monthly home expenses (your monthly mortgage payment, property taxes, heating bill, and condo fees), but it also includes your monthly debt payments. Monthly debt payments include revolving and installment debt, such as outstanding balances on your credit cards, personal loans or lines of credit, student loans and car loans.
The TDS ratio looks at the percentage of your gross monthly income required to cover the monthly home expenses and debt. You should aim for a TDS ratio below 40 per cent. If you have a high credit score, banks are often willing to raise the maximum ratio to 44 per cent.
How to Calculate the TDS Ratio
To calculate your TDS ratio, use your bank statement to add up your monthly home expenses and debt payments. Once you have the total, divide it by your gross monthly income and multiply by 100 and voila, you have your TDS ratio!
TDS Ratio Formula:
TDS = (PITH + ½ Condo Fees + Monthly Debt Payments)/Gross Monthly Income x 100
P = Mortgage Principal
I = Mortgage Interest
T = Property Taxes
H = Heating
For example, if you have a monthly mortgage payment of $1,280, property taxes of $240, monthly heating bill of $110, monthly student loan of $280 and gross monthly income of $5,900, your TDS will be:
TDS = ($1,280 + $240 + $110 + $280) / $5,900 x 100 = 32.37%
Your TDS is well below the maximum of 40 per cent, so you shouldn’t have any issue paying for your property on a monthly basis.
What if My Debt Service Ratios are Too High?
Just because your debt services ratios are higher than the industry standards, doesn’t mean you have to throw in the towel on your dream of homeownership. There are steps you can take to improve your debt service ratios.
You should start by looking at why your debt service ratios are high. Is it because you’re purchasing a home you simply can’t afford? Is it because you’re carrying too much debt? Although debt won’t affect the GDS ratio, it will certainly affect the TDS ratio.
The easiest way to improve your TDS ratio is to concentrate on paying down your outstanding debt. Once you’ve paid the monthly minimum payments on your debt, you should use any leftover money towards paying down the highest-interest debt, which is typically credit card debt. Furthermore, you can improve both ratios by saving up a larger down payment or purchasing a home with rental income.
While the debt service ratios are important, they aren’t the only thing lenders consider when reviewing your mortgage application. Other factors include the loan-to-value (LTV) ratio and your credit score. By boosting your down payment and improving your credit score, you can help improve your chances of obtaining a mortgage.
For more information on the debt service ratios and to calculate your own, please visit CHMC: Are You Financially Ready.
