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When you apply for a mortgage to buy a home, one of the first things your lender will want to figure out is whether or not the mortgage will be affordable. In other words, is your income sufficient to manage the monthly mortgage payment as well as your other financial obligations? To figure this out, your lender uses something called a debt-to-income ratio, also known as a debt servicing ratio.
Debt-To-Income Ratio Definition
Your debt-to-income ratio (DTI) measures the percentage of your gross monthly income that is used to service the payments on your debt. In the credit granting process, lenders look at two separate debt-to-income ratios when assessing your creditworthiness: gross debt servicing (GDS) and total debt servicing (TDS).
To avoid confusion, DTI is also used in reference to a larger-scale financial indicator – that is, measuring a household’s overall debt load against its gross annual income. That would look something like this:
DTI = (Total debt, including mortgage, car loan, credit cards, etc. / Annual gross income)
While we won’t cover the calculation in this article, it’s a good measurement of one’s overall financial health. In 2019, the average Canadian family had a DTI of 177%, a number which has risen steadily over the years. This means Canadians owe $1.77 in debt for every dollar of income.
How To Calculate Your Debt-To-Income Ratio
Gross debt servicing refers to the percentage of your gross monthly income that’s used to cover your mortgage payment, including property taxes and utilities. Ideally, this won’t be more than 32%.
GDS example: Let’s say you have a monthly gross income of $8,000 and the mortgage you’re applying for has a monthly payment of $2,200, which includes $200 in property taxes as well as an estimate of $150 for utilities. If you divide $2,200 into $8,000, your GDS would be 27.5%, which would be considered reasonable.
Total debt servicing is the percentage of your gross monthly income used to cover the payments on all your debt. This includes not only your mortgage but payments on credit cards, car loans, lines of credit and even student loans. The maximum allowable TDS is 40 – 42%, but the lower it is, the better.
TDS example: To add to our previous example, in addition to the $2,200 mortgage payment, you have $800 of additional monthly expenses. This includes a $450 car loan, a $200 payment on a line of credit and a $150 credit card payment. This brings your total monthly obligations to $3,000. Dividing that amount into $8,000 results in a TDS of $37.5%. In other words, 37.5% of your monthly income goes toward the payments on all your debt. This would be considered acceptable since it is below 40%.
How Much Can I Spend On A House?
Now that you know how to calculate GDS and TDS, you should be able to figure out how much of a monthly mortgage payment you can afford. But how does that translate to the actual purchase price of a home? To figure that out, you’ll need to use a mortgage payment calculator and know how much you plan to contribute as a down payment.
Mortgage calculators are readily available online. Simply plug in a few details, such as the mortgage amount and interest rate, and it’ll calculate your monthly payment. Your down payment can be used to bridge the gap between your maximum mortgage amount and the purchase price of the home.
Why Is Your Debt-To-Income Ratio Important?
Your debt-to-Income ratio is important because it gives a lender an indication of your ability to manage your mortgage payment. It also helps them better advise you on your mortgage options. It doesn’t matter how much money you make; if more than 40% of your pretax income is being used to service your debts, your lender knows that cash flow is going to be pretty tight, making it difficult to set money aside for other purposes, such as savings. It’s an indicator you may not be in a good position to absorb a financial shock such as a sudden loss of income.
Even though the lender is taking your house as security for the mortgage, they never want to be in a position where they’re forced to foreclose, having to dispose of your property to recover the mortgage balance owing. They use your DTI to ensure you can afford to repay the money you’re borrowing.
Ways To Lower Your Debt-to-Income Ratio
If your DTI is out of line, then either your income is too low or your debt load is too high. Sometimes it’s a combination of both. The easy solution would be to look for a cheaper home because the lower mortgage payment and presumably lower property tax bill would improve your affordability.
If you don’t wish to compromise on the house you want to buy, there are ways you can lower your DTI. Here’s a list of steps you can take:
- Accelerate your debt payoff. Eliminating even one loan can dramatically improve your mortgage affordability. It’s one less payment to be included in your TDS calculation.
- Increase your down payment. A larger down payment reduces your required mortgage amount and lowers your GDS.
- Consolidate your debt. If you have several monthly payments you’re struggling to stay on top of, combining them into one loan may not only save you interest, but could reduce your payments as well.
- Ask for a raise at work. It’s not easy to ask for a raise or a promotion, but if you’re a valued employee, your boss will want to keep you happy. Be prepared to explain why giving you more money is the right decision for the company, and don’t be shy. After all, what’s the worst that can happen? They say no?
- Start a side hustle. There have never been more opportunities to make extra money. Find something you enjoy doing and look for a way to make money doing it. You may not be able to use your side hustle income in your mortgage application, but the extra money can go into your savings account toward a larger down payment.
- Reduce your credit card usage. It’s easy to get caught in the trap of spending on items we don’t need, especially when using a credit card. It makes it too easy to spend, and the balances start to add up.
Final Thoughts On Debt-To-Income Ratio
If you don’t like any of these ideas, you may need to make a compromise on the kind of house you’re trying to buy. Or perhaps look in a different location. You may be able to find an equivalent home at a lower price in a slightly less desirable area. The bottom line is that there are things you can do to improve your DTI if you’re willing to be creative.
Tom Drake is an authority in Canadian personal finance. He is a financial analyst and has been writing about personal finance since 2009 at the award-winning MapleMoney. His work has appeared in MintLife, Canadian MoneySaver, and U.S. News & World Report, and has been quoted in The Globe and Mail, Yahoo Finance, and Financial Post.