There are rules of thumb that help you to guestimate what you’ll be able to afford when you go hunting for a home to buy. One rule of thumb is that you can afford to spend 2.5 times your gross household income. In other words, if you and your pal make $100,000 between you before taxes, you can spend $250,000 on a home. Some of these rules of thumb go as high as 5 times your annual income, but we know that lending has become less sensible of late, and I believe if you go over the 2.5 – 3 times your income, you’re being overly optimistic, unless you have a whopper of a downpayment.
Nothing beats knowing the actual calculations lenders use to decide if you’ll qualify for a mortgage. To determine how much you can actually afford to pay each month for mortgage payments most lenders calculate your “debt service ratio.”
There are two different debt service ratio calculations. The first, Gross Debt Service Ratio, or GDSR, deals with the percentage of your gross income it’ll take to cover your housing costs including mortgage payment, taxes, heating costs, and half your condo (or strata) fees. Lenders don’t want you to spend more than 32% of your gross monthly household income on combined housing expenses.
Let’s say you go for a mortgage and you have no debt. Your housing costs (mortgage payment, taxes, heating costs, condo fees) will be $1400 a month. Your gross family income is $4,500. Your debt service ratio would be 1500 divided by 4500 multiplied by 100 (1400/4500*100) = 31%
You’re below the 32% -cut-off for allowable GDSR, so you MAY qualify for the mortgage. I say, MAY because there’s still another hurdle for you to leap over before you know for sure.
The second calculation – Total Debt Service Ratio, or TDSR, is everything in your GDSR calculation PLUS all your debt payments divided by your gross family income and it tells lenders whether you’re going to be able to pay them back. Your total debt service ratio needs to be under 40% for lenders to feel safe giving you their money.
Continuing with the previous example, let’s say you had a car loan that was costing you $450 a month. You’d have to add that $450 to the equation: 1400+450/4500*100 = 41%, which is over the acceptable limit. Result: You’re declined.
Your car is paid for, and you have no other loans, so you’re in the clear. How about that line of credit you’ve been trying to get paid off for the past two years? That’ll have to be factored in. So will those student loans that have been following you around for the past six years. And then there are your credit cards.
“I don’t carry a balance on my cards,” you announce proudly, “so they won’t be a factor.”
So you think. How many cards to you have in your wallet and what are limits on those cards?
“$4,000, $6,500 and $8,300.” So that’s a total of $18,600 in credit.
“But I don’t carry a balance” you protest. “I pay my cards off every month. Besides I never even get close to those limits.”
The lender doesn’t care. Since you COULD run those limits to their max, that’s all the lender cares about. So s/he adds in the minimum payment you’d have to make to keep all that credit balanced. Assuming s/he used 2.5% (pretty standard for minimum payments), s/he’d add in $465. Hey, wait a minute. That’s even more than the car payment so there’s no way you’d qualify.
Can you see why borrowing money willy-nilly can really be a bad idea? All those dinners out, those I- just- have- to- have- it- NOW purchases, those unplanned-for expenses, and those but- I’ve- been- working- so- hard vacations will come back to bite you in the butt if you’ve put them on credit.
Want to work out your GDSR and TDSR to see how you’re doing? You can get out your own calculator, or you can use this one on the web.
Don’t go underestimating what you debt repayments will be in an attempt to fool the calculator into giving you good news. If you don’t use the actual minimum you’re required to repay on your debt, you’re just setting yourself up to be disappointed when you do finally get to the lender.
Assuming your have no debt at all (yippee!), and all you have to think about is your GDSR, you can simply take your monthly gross income and multiply it by 32% to figure out the maximum you can afford for your mortgage payment, property taxes, heating costs, and half your condo or strata fees.
Let’s say you have a family income of $7,500 a month. Multiplied by 32%, you’re working with $2,400 for your total housing costs. If we estimate your property taxes at $200 a month, your heating costs at $150 and your ½ your condo fees at $125, the total amount of your mortgage payment would could be as much as ($2,400 – [200+150+125]) = $1,925.
So, how much home does that translate into. Well, it depends. First, it depends on how much of a downpayment you have. Second, it depends on how long you’re planning to carry your financing. Third, it depends on the going rate of interest.
The bigger your downpayment, the more house you can afford.
The longer you amortize your mortgage, the more house you can afford. But the more your home will end up costing in the end. Amortize for 25 years, and you’ll end up paying twice the orginal price of your home. Amortize for 40 years, and you’ll pay three times the original price of your home.
The lower the interest rate, the more house you can afford. Keep in mind that you shouldn’t go to your borrowing limit based on low rates since you have to consider how your cash flow will be affected when you renew if rates are up a point or two.
Of course, the easiest way to figure out how much house you can afford is to get pre-approved for a mortgage by a lender. That’ll take all the guess-work out of the experience. Not quite ready to hit up a lender, then try this online calculator.