Understanding Mortgage Borrowing Capacity
In Canada, buying a property typically depends on obtaining a mortgage loan. The future buyer must complete several steps before reaching the final stage, represented by receiving the keys to their new home. Knowing your mortgage borrowing capacity is part of this process. As mortgage brokers, we recommend that prospective borrowers obtain a mortgage pre-qualification to know their borrowing capacity before planning a property search that matches their lifestyle and preferences.
What is mortgage borrowing capacity? How can a borrowing capacity calculator from mortgage brokers help estimate this amount? Learn all about borrowing capacity with advice from your mortgage brokers.
Interested in discussing mortgage borrowing capacity with a broker?
What is Borrowing Capacity?
To increase your chances of achieving your real estate project, one of the first steps is to understand your borrowing capacity—the amount you can borrow as a mortgage loan. Borrowing capacity represents the maximum amount a borrower can obtain, considering annual income, current financial commitments, housing costs, and ongoing expenses related to a new home. The most common financial commitments for a buyer include personal loans, credit cards, rent, condo fees, and personal lines of credit.
Practically, calculating a borrower’s amortization ratios is always necessary to determine borrowing capacity. Two key indicators assess a mortgage credit applicant’s finances: the Gross Debt Service Ratio (GDS) and the Total Debt Service Ratio (TDS). The debt service ratio is essential for understanding the borrower’s repayment ability.
Your borrowing capacity can be calculated using an online capacity calculator provided by your mortgage broker. This indicator depends on several factors. Your income, monthly expenses, down payment, and existing debts are the main factors influencing borrowing capacity. Lenders generally use GDS and TDS ratios to determine your capacity, with gross income also being a critical factor in these calculations.
Knowing your borrowing capacity is helpful. This step usually precedes the entire process of applying for a mortgage loan. The amount obtained through calculation helps set a potential budget for your future home purchase, facilitating mortgage accessibility.
Understanding your borrowing capacity allows the buyer to better target property searches and avoid excessive debt on their mortgage. This approach ensures protection against potential long-term financial difficulties by helping the borrower determine the most appropriate amount for mortgage payments based on current financial capabilities.
Determining the Down Payment
The mortgage borrower contributes to financing their future property through a down payment. This financial contribution from the borrower is deducted from the purchase price of the future home, with the mortgage loan covering the remaining balance.
The amount of this required contribution is expressed as a percentage of the property’s purchase value.
Minimum Down Payment Based on Purchase Price
A minimum percentage is required for the down payment, depending on the property’s price:
- When the purchase price is up to $500,000, the minimum down payment is 5% of the purchase price. For instance, for a $450,000 property, the minimum down payment is $22,500, with the remaining $427,500 financed through a mortgage.
- When the purchase price is between $500,000 and $999,999, the minimum down payment is 5% of the first $500,000 plus 10% of the portion between $500,001 and $999,999. For a $650,000 property, the borrower must provide a minimum down payment of $40,000 (5% of $500,000 and 10% of $150,000), with the mortgage covering $610,000.
- If the property value exceeds $1,000,000, the minimum down payment is 20% of the purchase price. For a $1,050,000 property, the minimum down payment would be $210,000, with the mortgage covering $840,000.
The larger the down payment, the less the borrower needs to borrow. The down payment amount affects borrowing capacity and the final amount the bank can lend for the real estate project. Determining the down payment is thus crucial before assessing borrowing capacity.
Mortgage loan insurance may be necessary, depending mainly on the borrower’s down payment. When the down payment is less than 20% of the property price, the mortgage lender will require loan insurance. The mortgage insurance premium is then added to the mortgage costs.
What Are the Conditions for Mortgage Insurance?
The Canada Mortgage and Housing Corporation (CMHC), Sagen, and Canada Guaranty are the primary organizations for mortgage insurance. A mortgage insurance contract is in place to protect the lender if the borrower defaults on the mortgage loan. Several criteria must be met for eligibility. For example, if choosing CMHC, the buyer must meet conditions such as:
- The property’s purchase price must not exceed $1,000,000.
- Housing expenses (including heating, property tax, and condo fees) must not exceed 39% of the household’s gross income (GDS ratio).
- The ratio between household debt and gross income (TDS ratio) should not exceed 44% of the household’s gross income.
- The credit score should be between 650 and 680 minimum. This indicator reflects the borrower’s risk level for financial institutions and their credit management.
- No loan should be used to finance the down payment. Since July 2020, CMHC mortgage insurance applicants must fund the down payment without a loan. Using savings or a relative’s support is a solution. However, Sagen and Canada Guaranty allow the down payment to be funded by a loan if its repayment is included in the TDS calculation.
What is the Gross Debt Service Ratio (GDS)?
Understanding borrowing capacity also involves knowing concepts like the GDS ratio (Gross Debt Service). This indicator represents the ratio between housing costs (including condo fees, property taxes, heating costs) and the borrower’s gross household income.
The formula for calculating the GDS ratio is:
GDS = (Debt and Housing Costs) / (Gross Income)
The borrower’s gross income can include salary and rental income. Family allowances, pension income, or long-term disability insurance income may also be considered.
What is the Total Debt Service Ratio (TDS)?
The Total Debt Service Ratio (TDS) is another essential indicator. Like the GDS ratio, the TDS ratio helps you better prepare for applying for a mortgage loan. Both the GDS and TDS ratios help determine your debt and expenses relative to your income.
The formula for calculating the TDS ratio is:
TDS = (Mortgage Repayment + Other Property-Related Expenses + Other Financial Obligations) / (Gross Income)
H3: Don’t Forget Closing Costs in the Borrowing Capacity Calculation
A borrowing capacity estimate is only complete when all aspects of the mortgage loan are considered. Closing costs are one of the factors to account for. In addition to the down payment, the borrower should also plan for these additional costs.
Closing costs represent the necessary charges to complete the property purchase, including legal fees, title insurance, transfer taxes, and possible inspections. These costs can be up to 1.5% of the property’s purchase price and must be covered by the borrower.
How to Increase Borrowing Capacity?
Understanding concepts like the down payment, mortgage insurance, closing costs, and GDS and TDS ratios helps better evaluate your borrowing capacity. If your borrowing capacity falls short of expectations, here are some tips to increase it:
- Pay off credit card balances and other debts, either partially or entirely.
- Reduce monthly expenses.
- Improve your credit score to a minimum of 680.
- Consider a less expensive property to lower monthly mortgage payments.
- Choose a longer amortization period to reduce monthly payments.
Conclusion
Borrowing capacity is an essential indicator for determining a borrower’s ability to repay a mortgage loan. Higher borrowing capacity facilitates securing a more advantageous mortgage rate. Knowing your borrowing capacity allows you to focus your search better and save time by avoiding properties beyond your price range.
