Whether you’re applying for a mortgage for the first time or are looking at purchasing a new home and will be increasing your mortgage amount, it’s essential to understand how much you can afford. You may think that any number that fits within your monthly budget is comfortable and sustainable, but your mortgage lender may say otherwise. In order to determine what you can truly afford, there are some guidelines that mortgage lenders insist you abide by and they can ensure that you don’t get in over your head with your home purchase.
How Mortgage Debt Ratios Determine Affordability
You might think that if you make $4,000 per month that $2,000 per month to carry your mortgage is quite affordable but it’s not quite as simple as that to a mortgage lender. What they look at is a few essential debt ratios that ensure you’re taking on a mortgage well within your means with consideration to your other debts and expenses.
Gross Debt Service Ratio (GDS)
The gross debt service ratio looks specifically at the affordability of your housing costs, and it requires that they are not higher than a fixed percentage of your household income, which can vary by program and lender.
The way the GDS is determined is by calculating the monthly mortgage amount + property taxes + condo fees, and then that sum is divided by monthly income. In the case of the $4,000 income and the $2,000 mortgage payment, with this equation, that is not an amount that a mortgage lender would provide a borrower as the ratio is far too high without even considering the other housing costs.
Total Debt Service Ratio (TDS)
Your total debt service ratio is also considered to ensure that you get a mortgage amount that is easily affordable. The same calculation for the TDS applies, but with this debt ratio, all debt obligations are considered whether it’s a car loan, student loan or minimum credit card payments for outstanding balances as well as your housing expenses. This debt ratio can be no higher than 40%-42% on some programs, but this number can vary by program and lender.
Ensuring Your Mortgage is Always Affordable
While it may seem as though the mortgage amount that you’re approved for based on the debt ratios is much lower than what you believe fits into your budget, this is a realistic amount for a number of reasons:
- As a general rule, having your total debt expenses total no more than 40% ensures you have enough cashflow for savings, investments, household repairs, day-to-day living expenses and more.
- When you take on a fixed rate mortgage for 2 or more years, there’s potential that in that time period your situation or income could change. With a GDS of 32% or under, it’s more realistic to expect that if that happens, it’s more likely you’ll be able to continue to pay your bills.
- You never want to become house poor or you’ll begin to resent your investment. When you don’t over-spend on your home, you’ll still have opportunity to live your life.
- When you first buy your home, you may have fewer expenses than you would if your life changes. For example, when you make your purchase you may only be a couple and if later you have children, your variable expenses may change greatly.