Financial freedom is either having the capital available or access to it when needed. Keeping a solid understanding of all the forms of debt you have is key to knowing your purchasing power. With interest rates being incredibly low, many people have inquired about the ability to borrow money and invest it to generate a return greater than the interest rate. The first stage is obtaining an understanding of your ability to take on more debt for business opportunities, upgrading a home, purchasing equity investments, or using leverage to enhance your growth potential (with added risk).
If you are meeting with your personal banker and you are interested in borrowing some money to purchase a home, the bank will need to know your current assets, your income, and your level of debt. With your consent, your bank will be able to access your Equifax or TransUnion credit reports which will provide a snapshot on most of your current debt obligations. It is one way the banks can verify the information that you are telling them is correct and relevant.
For purposes of this article, we want to focus primarily on the debt side of lending. The assets and income part also must be addressed as it is linked to some of the key metrics that determine whether the bank will lend you money. We will look at the key ratios, what impacts your ability to borrow, and some common examples of debts and their potential impact to your purchasing power.
Key ratios to understand
There are two key ratios used by the bank that consider both income and debt to determine whether one qualifies for a mortgage:
1. Gross Debt Service Ratio (GDSR)
The first is the Gross Debt Service Ratio (GDSR), which is used for default insured mortgages. A default insured mortgage is a mortgage with less than a 20 per cent down payment. The GDSR the lender is comfortable with is around 39 per cent, and it is the ratio of principal residence housing costs to income. Principal residence housing costs include mortgage payments, property tax, and heat. If the mortgage is for a condominium, the GDSR will also include 50 per cent of monthly maintenance fees. Scotiabank calculates GDSR for all retail credit applications because it is a component of total debt service; however, GDSR is primarily used for default insured mortgage applications.
To illustrate, Mr. Smith is looking to purchase a principal residence for $900,000. He has a 10 per cent down payment, or $90,000, plus additional funds for closing costs. As this is an uninsured mortgage (the down payment is less than 20 per cent), Mr. Smith must also pay mortgage insurance of $25,110, which he will add to his mortgage. The total mortgage will be $835,110 ($900,000 purchase price - $90,000 down payment + $25,110 mortgage insurance).
Mr. Smith earns a monthly salary of $10,000 before tax. The property taxes are $400 per month and utilities are expected to be $150 per month. Monthly mortgage payments will be $3,448 based on an $835,110 mortgage, 25-year amortization, and 1.78 per cent interest rate on a five-year fixed term. Total monthly expenses are $3,998 ($3,448 mortgage payment + $150 utilities + $400 property taxes). Mr. Smith’s GDSR is 39.98 per cent ($3,998 in monthly expenses divided by monthly income of $10,000). With the GDSR at a maximum of 39 per cent, Mr. Smith does not meet this requirement.
2. Total Debt Service Ratio (TDSR)
The Total Debt Service Ratio (TDSR) is the other key ratio, and it applies to both uninsured mortgages (mortgages with a 20 per cent or more down payment) and default insured mortgages. The TDSR that the bank is comfortable with is around 44 per cent, or lower in some cases. It includes total housing costs, as described above in GDSR, plus all other debts, divided by gross monthly income.
It is important to note that the 39 per cent GDSR and 44 per cent TDSR that the lender is comfortable with may decrease depending on if the client has a poor credit history (as noted in the Equifax or TransUnion reports).
To illustrate the TDSR, Mr. Jones is looking to purchase a principal residence for $1,000,000. He has a 20 per cent down payment, or $200,000, plus additional funds for closing costs. The total mortgage will be $800,000 ($1,000,000 purchase price - $200,000 down payment).
Mr. Jones earns a monthly salary of $11,000 before tax. The property taxes will be $500 per month and utilities are expected to be $200 per month. Monthly mortgage payments will be $3,303 based on an $800,000 mortgage, 25-year amortization, and 1.78 per cent interest rate on a five-year fixed term.
Mr. Jones has utilized $15,000 of his unsecured line of credit (LOC). Typically, the banks would multiply this revolving debt owing by three per cent to get the monthly payment for the debt calculation. The monthly debt obligation linked to the line of credit is $450 ($15,000 x three per cent). Mr. Jones’ total monthly costs for the TDSR are $4,453 ($3,303 mortgage payment + $500 property taxes + $200 utilities + $450 for the LOC payment). This figure of $4,453 divided by Mr. Jones’ gross monthly income of $11,000 gives a TDSR of 40.48 per cent, which is below the TDSR maximum of 44 per cent.
The loan-to-value (LTV) percentage is what is commonly referred to as the debt to equity ratio. Scotiabank can refinance a home up to 80 per cent of it’s LTV. For example, if you buy a rental property, you need to have a 20 per cent down payment, which translates to an 80 per cent LTV (100 per cent value of the property – 20 per cent down payment = 80 per cent LTV).
If you purchase your primary home/personal residence, you can finance up to 95 per cent. This would require a default insurance premium attached to the overall mortgage and paid over the 25-year term of loan. If you put 20 per cent or more down, you do not require the default insurance premiums. This is considered uninsured.
Line of credit
As shown in the example above, Mr. Jones had an unsecured $15,000 line of credit outstanding. In calculating the TDSR, the banks will typically take three per cent of the outstanding amount to get the monthly payment for the debt calculation. The monthly debt obligation linked to the line of credit is $450 ($15,000 x three per cent).
Many of our clients have a home equity line of credit (HELOC) that is not utilized. For example, our clients who have a $500,000 line of credit have the ability to borrow that money but may not have utilized it. Some people may feel that a HELOC that is not utilized may impact their ability to obtain other forms of debt, but typically this is not the case. If the HELOC is not being utilized, it should not impact your ability to access a different form of debt. If there is a balance on the HELOC, then this will impact your ability to take on more debt.
At Scotiabank, when the line of credit has an outstanding balance over $50,000, the monthly debt payment is calculated based on the balance, the five-year Bank of Canada benchmark interest rate, and over a 25-year amortization. This payment is usually much lower than multiplying the outstanding balance by three per cent, which helps the client.
Owing money on a credit card also impacts your ability to borrow further funds. If you have a balance of $5,000 owing on your credit card, then this must be factored into your current debt obligation. Similar to a line of credit, the banks may multiply this by three per cent to calculate the monthly debt obligation.
The term “credit utilization” is a term that is used in banking. For example, if you have a $20,000 limit on the credit card and you have an outstanding balance of $5,000, then you are effectively 25 per cent utilized ($5,000 divided by $20,000). If you’ve utilized 100 per cent of your credit card limit, this will negatively impact your credit score. If you have missed payments, or made late payments, this is also a negative on your credit score.
Most people have a credit card with a limit substantially higher than what they typically utilize. For example, you could have a credit card with a $20,000 limit, but you never utilize more than $2,000. Does having a higher authorized limit on your credit card impact your ability to borrow further funds? Generally, the answer to this is “no” as it is not factored into the GDS and TDS ratios.
Did you recently purchase a car and have the salesperson propose zero down and zero interest for 12 months, with monthly payments over three years? Let’s say the monthly car payments are $850 per month. This would significantly impact the debt obligation.
This can be illustrated by revisiting Mr. Jones’ case from above. If Mr. Jones had to make car payments of $850 per month as well as his other monthly debt payment obligations of $450, he would no longer qualify for the mortgage: $3,303 mortgage payment + $500 property taxes + $200 utilities + $450 LOC payment + $850 car payment = $5,303. This translates to a TDSR of 48.21 per cent, which is above the TDSR maximum of 44 per cent.
Disclosure of child or spousal support payments
Those couples that have gone through a divorce or separation may have either child or spousal support obligations. Those obligations are not something that shows up in the TransUnion or Equifax credit reports. I’ve had people ask me how these payments impact the debt obligation and purchasing power. The answer depends on the information the bank asks and the information the client discloses.
If a client discloses to the bank that they pay child support or spousal support, then this will affect their mortgage approval amount. The bank will ask for the divorce or separation agreement to confirm the support payment obligations. These amounts will be factored into your TDSR (up to 44 per cent income to debt, as noted above).
However, if the client is not required to disclosure this, the bank would not know to include these payments as they do not show up on the client credit bureau reports and this would not be included in the application approval amount.
Student loans are factored in slightly differently than regular lines of credit when calculating the GDSR and TDSR. If the student loan doesn’t have to be repaid yet, the amount will be calculated like a revolving line of credit with a set percentage of the balance under $50,000. If the balance is over $50,000, the monthly debt payment is calculated based on the balance, the five-year Bank of Canada benchmark interest rate, and over a 10-year amortization. If the student loan is being repaid, the actual monthly payment amount will be used. Each bank will have set policies on how they factor in student debt in the application of further debt.
Combined affect of different debts
Before taking on additional debt, it is worth considering how the new debt will affect your purchasing power when combined with all other forms of debt. Looking at Mr. Jones as an example, he was able to take out a home mortgage in our initial TDSR example, but after factoring in the monthly car payments of $850, he no longer met the TDSR requirements. In this scenario, Mr. Jones either must make more money, or reduce his monthly debt payments. With the first option not always being attainable, looking to reduce his monthly debt payments, or buy a cheaper principal residence, may be his best option.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email email@example.com, or visit greenardgroup.com.