When we decide to own a home or purchase a property, the first step is to get the qualification done from a financial institution. In this article, we will determine what happens in the background and how a lender determines our qualification. This will help you to better understand the process and be well prepared for the eligibility even before reaching out to the lender.
Lenders across rely on two measures of ability for a borrower to pay back the mortgage payments, these are GDS (Gross Debt Service) and TDS (Total Debt Service), let’s understand these.
Gross Debt Service Ratio – GDS Ratio is the percentage of the Gross Annual Income of the household which is used for payments related to housing (PITH – principal, interest, house tax, heating costs). The lenders use GDS Ratio to qualify and determine the affordability of a household for mortgage purposes. If the qualification is being done for buying condo property, 50% amount of condo fees is also taken into account.
Total Debt Service Ratio – TDS Ration is similar to GDS, however, along with house-related payments it also includes any other debts which household has. So, any credit card payments, car loan payments, personal loans, alimony etc are to be taken into consideration. The industry standard guidelines used for GDS is 32% and for TDS is 40%.
Note: If the borrower is taking an insured mortgage (one with less than 20% downpayment), the principal and interest must be based on total insured loan amount including the CMHC premium for mortgage insurance.
We understood about the numerator for calculating these ratios – Principal, Interest, House Taxes, Heat Cost, and Debt Payments. Let’s go slightly more in detail to understand what can be included in the Gross Annual Income.
Employment Income – it is considered when it is a full-time position and the borrower is not on a probation. This is verified through recent pay stubs and an employment letter. Sometimes the financial institution will call your employer to verify the employment.
Variable Income – like Bonuses, commissions, seasonal jobs, investment incomes must have been sustained over a minimum of 2 years.
Self Employed Income – Determined by the lender using the NOA for past years, they average the income for last two years to account for fluctuation; or if the income is increasing for last 4 years in a row, they consider the most recent year income.
Let’s take an example to make this clear, Smith household has a gross family income of $85,000 ($7,083 per month). Their monthly house payment including the house tax and heating cost is coming at $2,200. They have car loan monthly payment of $400 and a personal loan monthly payment of $300. They are going for an insured mortgage with less than 20% down payment.
GDS = 2,200/7,083 = 31%
TDS = 2,900/7,083 = 41%
So, here in the above example with see that GDS is alright, however, TDS is higher, but can be improved by repaying the car loan to qualify for the mortgage. So, if the purchases pay the outstanding car loan their ratio is improved.
TDS = 2,500/7,083 = 35%
It would be important to note that the GDS and TDS ratio ceilings would vary based on lender to lender; also for applications, they might be lenient based on other strong aspects of the application.
The next question is that what one can do when the ratios are high to improve and lower them and increase chances of getting a clean qualification.
1) Reduce your debt where possible to reduce your monthly commitments.
2) Lower your range for selecting a property.
3) Increase your down payment towards the purchase.
4) Extend the mortgage term (if possible).
5) Ensure to reflect your correct family income.
There is another aspect which is completely out of your hand, banks sometimes would go in for an appraisal of the subject property, if they come up with an appraisal less than your purchase price, you might have to come up with additional down payment to complete the deficit. This can be avoided by making sure when you purchase a property, you are not overpaying and are buying based on the similar spec homes sold in last 30-45 days in the immediate neighborhood.
When a financial institution qualifies you for a certain amount, at your end do a simple calculation of your cash flow and try to avoid buying a home which your family income cannot afford. With time the financial situation changes for everyone and there would be enough opportunities to upgrade, you are buying a home for enjoying and not getting any undue stress.
Hope this article helped you to understand the intricacies of the qualification criteria for the lenders.