A mortgage is likely the biggest personal loan that you would ever take in your life. With the huge face value of the loan that the lender extends, they want to be sure of a few things before they qualify you for a mortgage:
That you are a good borrower. This is done by looking at your Credit Score.
That you have a stable income to make regular payments to pay the interest and repay the loan. For this, the lender will require a list of documents verifying your employment and income.
That you don't overextend your ability to repay the loan, meaning that the burden of the monthly mortgage payment is not putting you in a mortgage-poor position when you don't have enough money for living. To do this, the lender will use the GDS and TDS ratios to calculate mortgage affordability for your income levels.
For each of the above points, the bank will want proof that you meet their minimum requirement. The bank will look at your Credit Score, and proof of employment, and will calculate the ratio between your monthly income and monthly mortgage payments. In this post, we will look at each of the above.
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How to qualify for a mortgage: Credit Score
To understand that you are a good borrower, the lender will access your credit score and will review your file. Different lenders will accept different levels of Credit Scores. The bigger banks will only accept Credit Scores of 650 and above. However, smaller lending institutions will often accept lower levels of Credit Scores. However, they will also charge higher interest rates and demand higher downpayment for those with lower Credit Scores to account for a potential borrower default risk. Using past statistics, lenders know that people with lower scores are more likely to default on their loans. Thus, most banks will choose not to deal with customers that have a credit score below a certain threshold.
The credit score is a numerical representation of your current and past credit behavior. The credit score can range between 300 (lowest for the worst credit) and 900 (best credit score).
The credit-scoring model used by Equifax and Transunion is based on the FICO (Fair Isaac Company) model.
Equifax’s credit score is called the Beacon Score while TransUnion’s is called Empirica Score. For the lender, the credit score plays a significant factor in the decision to lend, and in determining the terms and conditions of that loan.
We have written an in-depth article about Credit Score, how it is calculated, and ways to improve them here: How to improve credit score? How is credit score calculated?
How to qualify for a mortgage using the GDS and TDS ratios. How much mortgage can I qualify for?
The next area that the lender will analyze when qualifying a borrower for a mortgage is the "affordability ratios" which are called GDS and TDS ratios. The GDS and TDS are debt service ratios that are designed to determine whether a mortgage payment can be afforded by the potential borrower. By using these ratios, the lender pre-qualifies a potential borrower. A debt service ratio is the ratio of debt to income expressed as a percentage. Lenders will use one or both of the above when looking at your income and the amount you want to borrow. Different lenders have different levels of debt service ratios. In our calculations, we use the industry standard.
Calculating the Gross Debt Service Ratio (GDS)
Industry Standard – 32%
The GDS is designed to determine if the potential borrower can afford the proposed mortgage payment based on his or her income (or a combined income, if there is more than one applicant). The GDS combines the costs that a potential borrower has regarding shelter and divides that cost by his or her gross income (the income before taxes are deducted).
The maximum ratio that is typical in the mortgage industry is 32%. This means that 32% of a potential borrower’s gross income may be used to service his or her shelter costs.
The GDS is calculated using the following equation:
GDS = [(PITH + ½ Condo Maintenance fee) / Gross Income] x 100
Let's take a look at the components of the above formula:
The PITH represents the Monthly Mortgage Payment (Principal and Interest), Property Taxes, and Property Heat. Let’s have a look at what each letter of PITH represents. Where no history is readily available, the heat costs used must be a reasonable estimate taking into consideration factors such as property size, location, and/or type of heating system. Most lenders will accept a standard amount of $100 per month for heat for most properties, while a higher amount may be used for a large property.
Condominium Maintenance Fee. The condo maintenance fee is the fee that a condominium unit owner pays to the condominium corporation for the maintenance of the common elements. If the property being mortgaged is not a condominium, this part of the formula is excluded. The GDS uses fifty percent of this expense.
Gross Income. The gross income is the potential borrower’s total income before paying income taxes.
Calculating the Total Debt Service Ratio (TDS)
Industry Standard - 40%
Like the GDS, the TDS is designed to determine if the borrower can afford the potential mortgage payment. However, this calculation also includes all other debts that the borrower has.
TDS is calculated by using the following equation:
TGS = [(Mortgage Payment + Property Taxes + Heat + ½ Condo Maintenance Fee + Other Debts) / Gross Income] x 100
Other debts can be defined as other obligations that, if the borrower failed to make a payment, would require monies to be paid to another party. For example, if a borrower had a car loan and failed to make his or her monthly payments, the car would be repossessed and the borrower would still owe the balance of the loan. If the borrower failed to make his or her monthly car insurance payment, on the other hand, the borrower would not owe any further money since the car insurer would cancel the insurance policy.
Examples of items included in the TDS ratio: | Examples of items not included in the TDS ratio: |
• Loans • Mortgage payments • Credit cards • Child support • Alimony • Any payment that, if discontinued, would result in a balance owing. | • Child care expenses (that are not court-ordered) • Food • Clothing • Entertainment • RRSP contributions • Car insurance • Property insurance • Life insurance • Any expense or payment that, if discontinued, would not result in a balance owing |
Now, let's use the above to answer the key question: How much mortgage can I qualify for?
As discussed above, the bank will want to make sure your monthly mortgage payments do not stretch your budget too much to make sure you can afford the monthly payment.
There are 2 steps to calculate how much mortgage you can qualify for:
Calculate the maximum amount of monthly payment the bank will allow using GDS and TDS ratios.
Using the monthly payment, calculate the total amount of mortgage the bank will give you.
Step 1: Let's take a look at a hypothetical example to calculate GDS and TDS and the maximum amount of monthly payment the bank will allow.
Let's say we want to buy a condo at $410,000 and have $40,000 as a down payment, resulting in a required mortgage of $370,000. The monthly mortgage payment on this proposed mortgage will be $2,150. Condo fees are $340 per month.
In our example, our monthly income is $7,500. We have car payments of $450 per month, credit card payments of $250 per month, and a student loan payment of $180 per month. The property taxes for this home are estimated to be $3,200 per year. We will use a ballpark of $100 per month for heat. Do we qualify for this proposed mortgage?
GDS would be calculated as:
The GDS is calculated using the following equation:
GDS = [(2150 + 3200/12 + $100 (heat) + ½ * $340) / $7500] x 100 = 35.8%
Please note some of the costs are monthly and some are annual, so we are dividing Property Tax by 12 months.
The TDS is calculated as:
TDS = [(2150 + 3200/12 + $100 (heat) + ½ * $340 + $450 + $250 + $180) / $7500] x 100 = 47.56%
As you can see, we would not qualify for a mortgage as for both GDS and TDS our scores are above what would be accepted by a bank. We would need to reduce the mortgage amount either by buying cheaper or providing a bigger downpayment. Other solutions could be to increase the amortization period for a mortgage or reduce other debts that feed into the above formula and increase our TDS ratio (e.g. can we close some of the loans to eliminate monthly payments?)
How to calculate the maximum mortgage payment you can afford?
Having stumbled into the situation above, you will likely want to calculate the maximum mortgage payment you can afford per month.
The formula for TDS would be:
Maximum Mortgage Payment = Maximum TDS * Gross Income - [Property Taxes + Heat + ½ Condo Maintenance Fee + Other Debts]
Maximum Mortgage Payment = 40% * $7500 - [3200/12 + $100 (heat) + ½ * $340 + $450 + $250 + $180] = $1583
You can use a similar approach for calculating your maximum mortgage payment to pass the minimum GDS requirement. Just remove the Other Debts and change 40% to 32%.
Step 2: Calculate the maximum mortgage the bank will give you.
There are 2 factors that will impact the maximum mortgage the bank will give:
The amortization period of the mortgage. You can pick one. The longer the amortization period, the more expensive house you can buy as you drag the payments longer and have to pay less every month.
The current interest rate for mortgages. Obviously, you are set to a certain range of interest rates currently offered in the market. However, you can still shop around for a better rate by contacting several lenders, contacting a mortgage broker, or choosing a variable rate that is usually better than fixed (however, you have to be mindful of the risks).
The formula for calculating the maximum mortgage amount is a complex one; however, you can replicate it in Excel.
Another way is to use an online calculator. There are quite a few of them online. For example, a simple-to-use calculator can be found on chase.com: How much mortgage can I qualify for?
In addition, many banks offer mortgage affordability calculators. Some of the calculators allow you to enter your current annual income, debts, and monthly expenses, so that they right away take TDS and GDS ratios into consideration and provide the maximum mortgage you can qualify for.
What happens if the maximum amount you can borrow is way below the desired home price. There are a few levers you can use here:
Increase amortization period.
Provide a higher down-payment.
Reduce monthly expenses. If you can find a way to pay off a debt that requires monthly interest payments this can help. Another way is to consolidate your debt into the mortgage.
Increase income. Check if you included all potential sources of income. Did you maybe forget the little interest coming from your savings account? Or could it be time to ask for a bit of raise from your employee? Obviously, this is hard to change factor, but income is likely the most important factor in the calculation.
Are you in the process of obtaining a new mortgage or are approaching the mortgage renewal? Whether you are applying for a mortgage first time in your life or have done it 20 times, the process may be stressful. Let us help you work through the application, document collection, and submission to a bank. Please do not hesitate to reach out to discuss your specific situation. Submit the application here and receive a free consultation:
Other factors lenders will analyze to qualify a borrower for a mortgage
The above 3 factors that we discussed are important for a lender in making their decision. However, there are a couple of other factors that may also impact their decision and help a borrower get better rates. These are the length of your employment with the current employee (if you are an employee), the levels of other debts you currently have, and how much net worth (assets) you have.
Lenders usually want to see that a borrower has had at least 2 years of employment with the current employee. Thus, if you are planning to obtain a mortgage, you may want to stick to your current job until you obtain a mortgage.
High levels of debt may raise a red flag for the lender even if this debt is not impacting your credit score. However, if you can prove that you are very much capable of repaying all your debt and the new mortgage this stops being a problem.
Lenders like to see that you have other assets such as cash, pension plan, other investments, property, etc. The logic is simple: if anything goes wrong with your source of income, you may use those assets to repay the mortgage and this creates a favorable image for the lender.
Documentation required for the Mortgage Application
As discussed at the beginning of the post, the lender will want to make sure you have a stable income as well as get the documents to verify the other information you are providing.
The lender will require the following documents for all mortgage transactions:
Employment Verification. Employment documentation requirements vary from lender to lender; however, below is a list of documentation that is typically acceptable for an employee:
T4
Pay Stubs
NOA (Notice of Assessment – often requested when there is commission income)
Letter of employment
Tax Return (also may be requested when there is commission income)
For a self-employed individual, the following list of documents may be required:
Financial Statements
Business License
Business Cheque
A consent form for the mortgage agent to use the applicant’s personal information for the purposes contained within the consent form.
Photo Identification. Photo identification is required to prove the identity of the applicant. The original document should be viewed and a photocopy obtained for the file.
Divorce/Separation Agreement (if applicable). If applicable this document outlines the terms and conditions of the separation or divorce and will typically include any payments that are required to be made for alimony.
Child Support Order/Agreement (if applicable). If applicable this document outlines the terms and conditions of child support, including any payments that are required to be made.
Specific Mortgage Documentation for a Purchase
The following is a list of documentation that is typically required when a client is purchasing a property:
Purchase and Sale Agreement
MLS Listing (for resale properties)
Proof of Down payment
Rental Letter (if applicable)
Real estate salesperson Information
Specific documentation for a Mortgage Refinance, Equity take-Out, and Switch
The following is a list of documentation that is typically required when a client is refinancing his or her current mortgage, taking equity out of his or her property, or switching lenders on renewal:
Current mortgage statement
Charge/Mortgage
Transfer/Deed
Property tax statement
Property insurance policy
Mortgage repayment history (if applicable)
In summary, we discussed the 3 key areas that the lender will look at for qualifying the borrower for a mortgage: employment and income stability, credit score, and the affordability calculation. Each of the above may impact the decision to qualify you for a mortgage or give the mortgage at better or worse terms. It is important to know your credit score, understand how much you can borrow, and know the list of documents the lender will require.
Most financial advisors suggest that people should spend no more than 28 percent of their gross monthly income on housing expenses and less than 36 percent on total debt, such as car expenses and credit card payments.