Are you hoping to buy a home soon in Canada? Understanding debt service ratios is vital to determining mortgage affordability. These calculations significantly influence whether lenders approve financing and for how much.
This guide will explain everything you need to know about gross debt service (GDS) and total debt service (TDS) ratios. You’ll learn what they measure, how to calculate them, their impact on mortgages, and proven strategies for optimizing your ratios. Let’s dive in!
What are Debt Service Ratios?
Debt service ratios, which include gross debt service (GDS) and total debt service (TDS) ratios, are two key calculations Canadian lenders use to determine mortgage eligibility and affordability. The GDS and TDS ratios compare your monthly housing costs and total debt obligations against your monthly gross income.
These ratios help quantify your current housing costs and additional debt obligations against your reliable monthly income and help lenders determine if your income reasonably supports taking on a mortgage payment and other housing expenses. Thus, lenders can appropriately assess risk and make informed, responsible lending decisions.
To be specific, your GDS and TDS can help lenders gain insight into:
- Your ongoing capacity and ability to handle the new mortgage payment long-term
- Whether you can continuously cover related property taxes, insurance, and maintenance
- If you have adequate disposable income left after housing costs to live comfortably
- Whether your total debts appear reasonably low or manageable compared to your income
- How prudently you have managed existing credit and financial commitments to date
Your ratios need to be within target ranges to get approved. Low ratios indicate that you still have a surplus monthly income after paying debts and housing costs. As the ratios creep higher, they suggest less affordability and capacity to cover the mortgage.
Aim to lower both your GDS & TDS. This shows lenders that you can responsibly manage debt and housing expenses. Too high ratios may lead to a denial of a mortgage application.
Meeting lender guidelines indicates you can sustainably manage mortgage payments and associated expenses without undue financial stress. That reduces the risk of default.
How to Calculate Your Debt Service Ratios?
How to Calculate GDS ratio
Your GDS compares your income to housing costs and expenses. It focuses solely on home-related costs.
GDS = (Principal + Interest + Taxes + Heat) / Gross Annual Income
The home-related expenses included when calculating your Gross Debt Service ratio consist of:
- The new mortgage’s principal & interest payments
- Property taxes
- Heating costs like natural gas and electricity
- 50% of condo fees, if applicable
- Any other housing expenses tied to the property
For example:
$2,000 housing costs
$6,000 gross income
GDS = $2,000 / $6,000 = 0.33 (33%)
A GDS of 33% means that 33% of this borrower’s income goes toward housing expenses.
Specifically, GDS helps indicate whether your income reasonably supports the new mortgage payment, property taxes, utilities, and other ownership expenses associated with taking on the property.
A lower GDS ratio signals greater affordability and budget room, while a higher ratio suggests you may be overextending your finances. Lenders prefer to see responsible, realistic GDS figures.
How to Calculate TDS Ratio
Your TDS provides a broader snapshot of expenses by incorporating housing costs and additional monthly debt payment obligations.
Total Debt Service Ratio = (Principal + Interest + Taxes + Heat + Other Debt Obligations) / Gross Annual Income
TDS helps identify whether your total debts, financial commitments, and housing expenses appear reasonably manageable based on your income.
Monthly debt payments included when calculating your TDS ratio may consist of the following:
- Minimum monthly credit card payments
- Car loans
- Personal loans
- Student loans
- Lines of credit payments
- Alimony or child support
- Other fixed debt obligations
For example:
Given $2,000 in housing costs and $500 in debt payments, the total costs are $2,500
Divided by $6,000 gross monthly income
TDS = $2,500 / $6,000 = 0.42 (42%)
Lenders prefer to see prudent, responsible TDS ratios indicating you live within your means. A lower TDS is generally better.
Calculating GDS/TDS seems simple. However, accurately estimating your current and projected housing costs, debts, and income is critical to calculating realistic ratios.
Online mortgage calculators and affordability tools can help determine potential monthly payments on a prospective property. Budget diligently and account for all existing obligations and new housing expenses. This ensures your ratios reflect reality.
GDS and TDS Ratio Standards in Canada
Most lenders establish maximum allowable Gross Debt Service and Total Debt Service ratio limits that mortgage applications should meet for approval. Let’s look at the standard ratio caps.
For insured high-ratio mortgages that require default insurance from the Canada Mortgage and Housing Corporation (CMHC):
- Gross Debt Service Ratio Limit: 39% Max
- Total Debt Service Ratio Limit: 44% Max
The industry standard for GDS is 32%, and for TDS is 40%. If you meet these points, the lender can be confident in your ability to pay your monthly housing costs. However, many applicants with good credit, assets, or additional income sources may qualify for a conventional mortgage with debt service ratios between 35-45%, depending on the lender’s underwriting policies.
How Debt Service Ratios Impact Mortgage Affordability?
Your GDS and TDS ratios directly influence how much mortgage you can qualify for and your overall home-buying budget. Here’s how debt service impacts your affordability:
- Lower GDS and TDS ratios allow higher mortgage approval amounts. More income for principal, interest, taxes and heating costs means increased borrowing capacity.
- Higher debt service ratios lead to lower mortgage approval amounts. Too much income allocated to existing debts restricts the amount available for new mortgage payments.
- Paying down debts improves ratios, allowing you to qualify for a larger mortgage. For example, paying off car loans can lower TDS and allow for a bigger mortgage.
- Letting ratios creep too high by taking on excessive debts will restrict mortgage approval potential.
- The mortgage stress test also plays a role. It calculates GDS/TDS at a higher interest rate, lowering affordability.
- Each lender has guidelines outlining the maximum GDS/TDS ratios they allow based on mortgage type. This determines the mortgage you can qualify for.
- Those with good credit, assets or other income sources may get more ratio flexibility, boosting affordability.
Why Does the Mortgage Stress Test Mess with Your Ratios?
Canada’s mortgage stress test requires you to qualify at an interest rate typically around 2% higher than your actual contract mortgage rate. This means your projected GDS/TDS ratios calculated during underwriting get artificially inflated compared to the actual mortgage rate.
For example, if your lender offers you a fantastic 3% mortgage rate, you must prove you can handle 5% or more payments during the stress test. That extra 2%+ rate gap will increase your calculated debt ratios, possibly pushing you over the limit.
Being mindful of the stress test’s outsized impact on your ratios is crucial when mapping out budgets and setting affordability expectations. You’ll likely need to opt for a significantly lower-priced home than without a stress test rule.
Also, remember that OSFI stress test rate requirements can change over time. Carefully follow the latest standards and account for the buffer required in your financial modelling and mortgage planning.
What If Your Debt Service Ratios Are Too High?
What can you do if your GDS or TDS ratios exceed the lender’s guidelines? Don’t panic! Here are 9 strategies to improve your standing over time:
Make a Larger Down Payment
Putting down a more substantial down payment upfront lowers the mortgage amount you need to finance. This directly reduces the housing costs portion of your ratio calculations.
If possible, aim to put down 20% or more. This will avoid the need for high-ratio mortgage insurance while maximizing affordability.
Pay Off Vehicle Loans or Other High-Interest Debts
Eliminating outstanding debts shrinks the debt payments portion of your TDS. Make an effort to pay off car loans, credit cards, personal loans, or other debts charging high interest first.
The less you owe each month to service existing debts, the greater your capacity to make a mortgage payment.
Choose a Less Expensive Property
Opting for a lower-priced home lowers your required monthly mortgage payment, improving your ratios. Set your sights on more affordable properties.
Add a Co-Signer
Finding a financially stable friend or family member to co-sign your mortgage can help supplement your income and ratios. Their additional earnings help compensate for any shortfalls you have.
Increase Your Income
Boosting your reliable monthly income rebalances debt ratios in your favour. Consider taking on a side gig, freelancing, or asking for a raise to grow your earnings. A higher income equals better ratios.
Extend Your Amortization Period
Spreading mortgage payments over a longer amortization period (25-30 years) reduces required monthly payments but increases total interest costs over the mortgage’s lifespan.
Explore Alternative/Private Lenders
Major banks are one of many options. Credit unions or private lenders may offer greater flexibility on qualified borrowers’ Gross and Total Debt Service ratio limits.
Wait to Buy and Improve Your Financial Profile
If your income or ratios need significant improvement, waiting an extra year or two before buying gives you time to save more, pay down debts and rebalance finances. Patience pays off.
With targeted effort and disciplined savings, you can enhance your ratios over time to become mortgage-ready.
Using Rental Income to Supplement Your Ratios
Earning rental income on investment properties or secondary suites may help supplement your debt service ratios under certain conditions.
Each mortgage insurer and lender has specific policies regarding how much rental income can be added to your total earnings when calculating Debt Service ratios.
Consult directly with your chosen lender and insurer to learn how supplemental rental income can improve debt service ratios.
The bottom line
Debt service ratios help indicate mortgage qualification chances and maximum affordable borrowing amounts for homebuyers and real estate investors. By understanding these ratios, carefully calculating your figures, and keeping your ratios within target ranges, you can smoothly navigate the financing process and increase your approval odds.
Some critical parting thoughts:
- Aim to keep housing costs below 32% of gross income per GDS guidelines
- Strive for total debts, including housing, under 44% per TDS guidelines
- Improve credit, pay down debts and build savings to enhance ratios
- Account for the mortgage stress test’s impact on your ratios
- Consider co-signers, alternative lenders and creative thinking
- Revisit your ratios annually and monitor changes over time
- Leverage the expertise of mortgage professionals wherever possible
With the proper preparation and knowledge, home financing is an achievable goal. At BestMO, we can find solutions that maximize your borrowing power and make homeownership achievable.
FAQs on Debt Service Ratios
What is a good GDS ratio in Canada?
GDS is monthly housing costs divided by gross monthly income. TDS is monthly housing + debts divided by gross monthly income.
What is a good TDS ratio in Canada?
40% or lower is recommended for conventional mortgages. Up to 44% is permitted with insured mortgages.
Do lenders allow rent to count toward GDS and TDS?
Yes, each lender has policies on counting a % of rental income when qualifying borrowers.
Can I get a mortgage if my GDS or TDS ratios are too high?
Yes, options include a co-signer, a larger down payment, an alternative lender, or improving ratios over time.
Why are lower GDS and TDS ratios better?
Lower ratios mean more income left over after housing costs and debts, indicating better affordability.
How much down payment do I need to improve my ratios?
Typically, 20%+ down keeps GDS under 32% and TDS under 40% for ideal ratios.
Can I ever exceed the maximum GDS or TDS ratio limits?
Yes, strong applicants with good credit, assets, or additional income may get flexibility on ratios between 35% and 45%.
What expenses are included in the GDS ratio?
Mortgage payment, property tax, heating costs, and 50% of condo fees are included in GDS.
What debts are included in the TDS ratio?
Car loans, credit cards, lines of credit, and other fixed payments are included in TDS.
What is Debt Service Coverage Ratio (DSCR)?
In commercial and investment real estate lending, the Debt Service Coverage Ratio (DSCR) is calculated instead of Gross or Total Debt Service ratios.
DSCR = Net Operating Income (NOI) / Total Annual Debt Payment
