Are you preparing for a potentially large home purchase? Houses don’t come cheap, and it’s vital to prepare well in advance to know the place you can afford.
You want to avoid purchasing a home that has expensive repayments that will cause you to struggle. It’s also essential to know the main factors mortgage lenders consider to avoid the pain of having your loan application rejected. So, here are the tips:
1. Determine your mortgage affordability
Mortgage affordability is the amount a person can borrow based on their current financial situation. The lender is obligated to calculate your mortgage affordability. They check if you’re capable of meeting the mortgage repayments and that you’re not at a high risk of defaulting. The factors they consider include:
- Gross Debt Service ratio (GDS): You’re going to use your income to pay the mortgage installments. The first rule is that total monthly housing costs (which include the mortgage payments, property taxes, heating costs, and other expenses) should not exceed more than 35% of your monthly income. In application, the mortgage lender will calculate the GDS by considering all the monthly costs brought about by purchasing the new home.
- Total Debt Service (TDS): Another requirement is that the total debt should not exceed 42% of the gross household income. The TDS factors and other monthly debt obligations include, car loans, personal loans, lines of credits, student loans, etc.
The TDS and GDS ratios change from time-to-time. For instance, the Candian Mortgage and Housing Corporation (CMHC) recently amended its debt-rate policy, and the new rates took effect from July 1, 2020. The new changes were expected to curb the borrowers’ purchasing powers, and despite the measures, the Canadian real estate market had a record year.
2. Consider the down payment amount
Having the requisite cash reserves to pay for a down payment is going to be very important in determining mortgage affordability. Typically, you’re expected to put down no less than 5% of the total sales price towards your mortgage down payment.
Accordingly, if you’re purchasing a home for $800,000, you need to have cash reserves of $40,000.
3. Set aside money for PST on Mortgage Default/CMHC Insurance
Are you planning to pay less than 20% towards the down payment? The loan will be deemed a high ratio mortgage, and you need to sign up for mortgage default insurance.
Borrowers may pay the mortgage insurance upfront as part of other closing costs. In most cases, the loan provider will pay the one-time premium and factor the cost into the regular monthly repayments.
While it may not be necessary to set aside money for CMHC insurance, you may need to pay the Provincial Sales Tax (PST). PST is a percentage of the CMHC premium, but it’s not required in all states. You need to pay the PST on the insurance premium in Quebec, Manitoba, and Ontario.
So how much will I need to pay for the mortgage default insurance? It ranges from 1.8% to 4% of the total mortgage. Typically, borrowers that pay a 5% down payment usually pay the highest rate. For instance, if you’re in Ontario and receive a $500,000 mortgage package, the CMHC insurance premium works out to $20,000, and it’s a requirement to pay 8% as the PST, so you’ll need $1600 during closing.
You can effectively reduce the mortgage insurance cost and PST by increasing your down payment.
4. Factor in additional closing costs
You need to set aside additional cash to cater to the closing costs, ranging from 1.5% to 4% of the home’s purchase price. The expenses are settled as part of the closing process, and they include:
- Home inspection fee (from $350 in most Canadian provinces).
- Land transfer tax
- Title insurance
- Legal fees and disbursements
- Appraisal fee (mostly paid by the lender)
What’s more, most realtors will ask buyers for the offer-to-purchase deposit. It’s not an expense, as it’s money you can recover if the deal falls through. Some buyers will ask for 1% of the sales price and some will ask for more. It just shows your commitment to purchase the property.
You can check out this page for more information on how to determine the mortgage you can afford and whether it makes more sense to continue renting: https://paradisedevelopments.com/blog/communities/renting-vs-buying-in-toronto/
Use a mortgage affordability calculator
Calculating mortgage affordability can be at times complex. Several mortgage affordability calculators have been developed to make this process easier and more intuitive. Just search for a free calculator online, and make sure it’s regularly updated as the GDS and TDS requirements change.
The yearly salary rule
The rule advocates that the total mortgage amount should not exceed three times your gross annual salary. You should also pay a 20% down payment and reduce your debts to have a low TDS percentage. But this sounds a bit strict considering the prices of homes! Well, it’s not carved in stone. Other experts recommend that the mortgage should not be 4 to 5 times greater than your household gross annual income.
About the 28%/36% Rule
There are many proponents of the 28%/36% rule, and it’s a rule of thumb followed by some homeowners to determine if they can afford their mortgages. It states that instead of the 35% GDS allowed by mortgage lenders, customers should instead consider spending no more than 28% of their gross income to cater for all housing-related costs. And instead of the 42% TDS, borrowers should not spend more than 36% of their income on outstanding debts.
Tips to increase your mortgage affordability
- Increase your savings leading up to a house purchase so you can afford a larger down payment and essentially reduce your mortgage default insurance cost.
- Shop around and get quotes from different mortgage lenders to find the lowest rate.
- Gradually improve your credit score and pay down some of your debts.
- Consider co-signing a mortgage to qualify for a larger loan amount, or to increase your eligibility.
- Look for ways to reduce the purchase price by negotiating, and don’t be afraid of walking away even in the competitive Canadian real estate market.
- Shop for cheaper houses that are within your budget. By lowering the purchase price, you avoid a large mortgage.
- Find ways to raise your income and acquire additional assets to appear more capable in the lender’s eyes.
You’ll be paying your mortgage for many years to come. Make sure that the repayments are manageable.
