Here’s part 3 of my 10 step series on mortgages here at Financial Uproar every Wednesday. Every step of the process will be covered from the application to qualifying to tips and tricks to save money on your mortgage and everything in between. To read all of these just click on the category Mortgage Basics.
Uh oh! This edition of mortgage basics is going to get a little math-y. Get out your calculators and your thinking caps. Yes, there will be a test at the end.*
Last week we focused on down payments and discovered that borrowing them is actually somewhat common. This time around we’re going to focus on one of the most important things of getting a mortgage: just how much can I afford. These are the actual ratios used by the banks and CMHC, so you’ll want to pay attention even if this gives you a math headache.
The Two Income Ratios
The two ratios that determine your maximum mortgage are gross debt service ratio (GDS) and total debt service ratio (TDS). The formulas are as follows:
GDS: Payment + Property Tax + Heat + ½ Condo Fees = less than 32% of gross income
TDS: Payment + Property Tax + Heat + ½ Condo Fees + All Other Debts = less than 40% of gross income
The formulas are much less complicated than they appear to be. If you made $72,000 per year (that’s $6,000) per month then all you’d need to do is multiply 6000 by .32 and .40 to get the maximums, in this case being $1920 and $2400.
What that means is $1920 per month maximum can go toward the mortgage payment, property tax, gas bills and half the condo fees (if applicable). This also gives the borrower a maximum of $480 per month of debt payments the lender will tolerate.
Depending on how high a borrower’s credit score is, GDS and TDS ratios can go higher. Any borrower with a credit score above 680 can have a GDS or TDS up to 44% of their gross income. The thought process is if your credit is great then you’ve earned the right to take on more debt if you so choose. Of course, taking on additional mortgage debt can be the first step into a debt nightmare, so borrowers would be wise not to max themselves out. If you are thinking of purchasing a house and looking for assistance with increasing your credit score, visit AAA Credit Guide to learn more about Lexington law here.
Real World Examples
Couple A makes a combined $80,000 per year. What’s the maximum mortgage they’d qualify for? They have excellent credit (both above 700) and have a car payment of $400 per month. They’re looking for a 5 year fixed rate of 4.5%.
Income: $6666 per month
Property Taxes (estimate) $400
Condo Fees: N/A
So we multiply $6666 by .44 to get $2933.33. This is the maximum the couple can pay for their commitments.
$2933.33-$400-$400-$85 = $2048.33
$2048.33 is the maximum mortgage payment this couple can have. Plugging that back into a mortgage calculator, it means the couple can max themselves out at $370.087, assuming they take out a 25 year amortization.
Here’s where it gets a little more interesting. That same couple can qualify for a mortgage over $435,000 if they extend their amortization out to 35 years. This keeps the payment the same, however they’re stuck forking over $2048 every month for 10 extra years. It doesn’t take a math genius to figure out the couple will end up paying tens of thousands of dollars in extra interest throughout the loan. 35 year amortizations are quickly going away, so if you want one, you better act fast!
If you want to do this exercise for your own situation, there are all sorts of calculators online. And of course, talking to someone qualified to give mortgage advice is recommended.
Where’s the Ideal Income Level?
Should you max out your mortgage and get the most you possibly can? I can think of almost no situation where you should go any higher than the 32% GDS or 40% TDS numbers. If you can’t qualify to buy a home without stretching your payments to higher than these levels then perhaps homeownership should be rethought at this point in your life. Or maybe that’s an indication that home prices in your area are too high and you are better off renting for the time being.
Another reason why you shouldn’t max out your mortgage is that interest rates are very low right now. You could lock into a nice 5 year fixed mortgage these days at a hair over 4%. But these rates won’t be here forever. You could be stuck having to pay 2-4% higher for the very same mortgage 5 years from now. Give yourself that buffer now while rates are low.
Dave Ramsey advocates spending no more than 25% of take home pay on housing. Unfortunately for Dave, for a lot of people in big centers that’s just unrealistic. If you can pull it off though, spending less on housing opens up more cash for saving and investing (or paying off the mortgage early). I always recommend people try to save money on housing whenever they can.
*Sorry if the math was too much for you. This was a fairly technical post, so I’ll omit the imaginary test I never did create. While mortgage math is tough, online calculators do make things easier.