While researching all that there is to know about mortgages, you might have come across the concept of debt service ratio (DSR). Debt service ratio is one of those fun financial terms that gets thrown around often with no real explanation of what it means. Fear not, because debt service ratios are actually not too difficult to get your head around.
It's important that you understand what your ratios are and how to calculate them because they are convenient indicators for your financial condition. They are also an important indicator that a lender will use to determine your mortgage loan terms and are an important factor in the mortgage stress test. For anyone looking to buy a home, this is a must-know.
What is a debt service ratio?
Debt service ratio is essentially the ratio between your income and your debt payments. This ratio is important because it’s a simple way to measure how effectively you can handle your debt payments based on your income. Your ratio is usually expressed as a percentage. For example, a ratio of 20% means that your annual debt payments make up 20% of your annual gross income.
It’s worth remembering that your debt ratios are calculated using your gross income, that is, income before deductions and taxes. That means that the percentage of your gross income that you want to put towards housing may be 20%, but in terms of actual disposable income, it will represent a larger percentage of your available funds.
What are the types of service ratios?
Your debt ratio is not actually a single figure. Rather, there are two major types of ratio, the gross debt service ratio (GDS) and the total debt service ratio (TDS). These measures are similar but have slight differences that make them useful in different situations.
Gross debt service ratio (GDS)
Your gross debt service ratio represents the ratio between your housing expenses and your gross income. Housing costs consist of your mortgage payments as well as monthly property tax payments, heating bills, half of your condo fee if applicable, and any other housing-related fees.
In order to calculate your gross debt service ratio for a house you don't own yet, you will need to calculate estimates for the various figures. Once you have your estimates simply divide these by your monthly gross (before tax) income. You can also use this calculation in reverse by dividing your income by a target GDS percentage. This will give you an idea of what sort of debt payments you can afford with your income.
Total debt service ratio (TDS)
Your total debt service ratio represents the ratio between all of your monthly debt payments, including housing, and your gross income. In addition to the housing costs from above, your total debt service ratio also accounts for any monthly debt payments you have such as credit card bills, car payments, line of credit payments, and more.
The calculation for the total debt service is essentially the same as for the gross debt service ratio once you include all additional debt payments.
Is rental income counted for debt service ratios?
If you already have rental income and are looking to buy another property, this net rental income will be included in your debt service ratios when applying for a new mortgage.
If you are applying for a mortgage on a rental property, you will only be allowed to include up to 50% of the potential gross rental income from the property as income for the purpose of calculating your debt service ratios. The one exception is if you plan to live in one of the units of a multi-unit rental as your primary residence. In which case, you may include 100% of the gross rental income towards your ratios.
Why do debt service ratios matter?
Debt service ratio is most important because it will play a role in determining your mortgage. Naturally, there is an upper limit on what monthly mortgage payments you can afford based on your monthly income. However, mortgage lenders will not let you spread your money too thin.
The Canada Mortgage and Housing Corporation (CMHC) sets limits on how high debt ratios can be in order to be eligible for a mortgage loan. Much like the mortgage stress test, the idea behind this choice is to prevent borrowers from taking on mortgages that they can not afford to maintain. The CMHC also puts a limit on debt ratio for borrowers looking to acquire mortgage default insurance.
If your debt ratio is too high, you will need to reduce it to a point below the maximums in order to be eligible for a mortgage. Otherwise, you will need to borrow from a private lender who does not observe the CMHC restrictions.
For GDS, the CMHC has a hard limit of 39%. Most banks try to keep their borrowers below 32% and will only offer loans at higher debt ratios in specific circumstances such as with a high down payment, good credit score, or valuable assets.
For TDS, the CMHC has a limit of 44%, though most banks will prefer a borrower to stay lower than 42% for mortgages.
How can I improve my debt service ratio?
If your debt ratios are too high to qualify for a mortgage, you will need to find a way to decrease them.
Because your GDS is often based on a hypothetical home you want to purchase, it’s the easiest to reduce. Essentially, you will need to alter the mortgage terms or find a different property. A longer amortization period or a lower-priced home can enable you to pay a lower monthly mortgage payment and free up space in your GDS.
Lowering your TDS is a bit harder because one main way to lower it would be to pay off debts. Naturally, everyone wants to pay off their debts as quickly as is reasonable, but there is not always a way to speed up this process. One thing you may be able to change is to increase your income through a job change or finding alternative sources of income. Again, this is not always in your control, but it is a good option if you can make it work.