When applying for a mortgage, your lender is going to take a variety of factors into account to determine whether or not you’re eligible for approval. One of the most important factors to consider is your debt-to-income ratio. A debt-to-income ratio is also used to determine how much you’re eligible to borrow from the lending institution, which then determines the type of home or neighbourhood you can buy in.
What is a debt-to-income ratio?
A debt-to-income ratio is a measure used by lenders to determine your mortgage affordability, calculated by overviewing your income versus debt. This ratio helps lenders determine how you’ll be able to manage your monthly payments, while repaying any debt you owe.
To calculate your debt-to-income ratio, you have to add up your monthly debt obligations (mortgage, student loans, auto loans, line of credit and/or credit card payments), divide it by your gross monthly income (income you receive before taxes and deductions) and multiply it by 100.
There are two types of debt-to-income ratios: gross debt service (GDS) ratio and total debt service (TDS) ratio.
A GDS ratio is the percentage of your income needed to cover your monthly housing expenses. Such housing expenses include principal, interest, property taxes and heat. This can be calculated by dividing the total amount of your monthly housing expenses by your gross annual income. Lenders are typically looking for borrowers to have a GDS ratio below 39% on their mortgage applications.
A TDS ratio is the percentage of your income needed to cover all of your monthly debts and expenses. These debts and expenses can include car loans, credit card debts and insurance payments. To calculate your TDS, simply add up all of your monthly debts and expenses and divide it by your gross annual income. Lenders are typically looking for borrowers to have a TDS ratio under 44%.
How does this affect my mortgage affordability?
Your debt-to-income ratio shows lenders how much debt you can manage based on your current financial situation and in the case of future financial difficulties or rises in interest rates. Lenders want to be sure that you’ll be able to weather unforeseen events should your circumstances suddenly change. By understanding the ratio between your income and the amount of expenses and debt you carry on a monthly basis, lenders can determine how much you’re eligible to borrow, while getting a clear picture of how many additional expenses you can take on.
One thing to keep in mind is that your debt-to-income ratio does not include expenses like food or home insurance. It’s important to take those additional costs into account to give yourself a more realistic picture of what your expenses will look like on a monthly basis. Check out the Homewise affordability calculator to get a quick high-level view of what you can afford based on your current income and expenses.