Most people understand what a credit score is and how it can affect your ability to borrow money or get credit cards. But your credit score isn’t the most important figure lenders consider when you apply for a mortgage.
While your credit score tells lenders how reliably you’ve repaid debts in the past, it doesn’t tell them whether you have the financial capacity to take on a mortgage. For that, they need to know about all your debt obligations and how these sums compare to your income. That’s what your debt-to-income ratio tells them
In some cases, a strong debt-to-income ratio can outweigh a so-so credit score; in other cases, someone with an impressive credit score might not qualify for a mortgage. Learning about debt-to-income ratio and how to calculate it will help you better understand your financial position and prepare to apply for a mortgage.
What Is Debt-to-Income Ratio?
Your debt-to-income ratio (DTI )is the percentage of your pre-tax income that goes toward recurring payments. Lenders use two versions of DTI:
- Gross debt service ratio (GDS) includes only your housing costs, including principal, interest, taxes, and insurance. This tells lenders how much of your income will go towards the home itself.
- Total debt service ratio (TDS) adds in your existing debts, including credit card minimum payments, loan payments, and personal lines of credit.
TDS is the more important figure of the two because it includes your home-related costs and all of your other debt obligations.
What to Include in a Debt-to-Income Ratio Calculator
To use a debt-to-income ratio calculator, collect this information:
- Gross monthly income, including:
- Employment income
- Commission-based income, based on two years of T4A or T1 general tax returns
- Child support and spousal support payments (add if these are made to you, subtract if these are made by you)
- Bonuses, based on at least two years’ history
- Self-employment income backed by documentation
- Pension income
- Disability benefits
- Rental income backed by a lease
- Investment income, if predictable and recurring
- Housing costs:
- Mortgage principal and interest (estimate these using an online mortgage calculator)
- Property taxes
- Heating costs (but no other utility bills, Internet, or cable)
- 50% of condo fees
- Homeowners insurance (depending on lender)
- Debt obligations:
- Minimum credit card payments
- Loan payments (car, student, personal)
- Line of credit minimum payments
Lenders may vary slightly in what they include as part of DTI calculations, but your estimate should come close if you use this comprehensive list.
With these figures in hand, you can determine the debt-to-income ratio
- GDS: (Housing Costs ÷ Gross Monthly Income) X 100
- TDS: (Housing Costs + Monthly Debt Payments ÷ Gross Monthly Income) X 100
For example, if your gross monthly income is $7000, your housing costs are $2000, and your other debt payments are $500:
- GDS: ($2000 ÷ $7000) X 100 = 33.3%
- TDS: ($2500 ÷ $7000) X 100 = 41.7%
Maximum Debt-to-Income Ratio in Canada
In Canada, the maximum allowable debt-to-income ratio depends on the type of mortgage and whether the mortgage is insured.
CMHC Insured Mortgages
CMHC-insured mortgages (for buyers with less than 20% down payment) allow a GDS of up to 39% and a TDS of up to 44%. In addition, at least one of the borrowers must have a credit score of at least 680.
Conventional Mortgages
With a conventional mortgage, lenders have more flexibility because mortgage insurance isn’t required. However, most major lenders prefer a GDS under 35% – 39% and a TDS of under 42% -44%.
Alternative Lenders (B Lenders)
Alternative lenders such as Home Trust Company, Equitable Bank, and many provincial credit unions offer more flexible lending than traditional banks. If you have a credit score below 600, have hard-to-verify income, or a limited Canadian credit history, these lenders are an option for you.
Alternative lenders can allow a TDS of up to 50%, and even 60% in some cases. These loans come at higher interest rates, often 1% – 4% higher than traditional lenders, but they are a resource while you’re rebuilding your credit or working on getting a more stable income.
Why Debt-to-income Ratio (GDS/TDS) Matters More Than Credit Score
There are several reasons why lenders rely on DTI more than credit score to decide on your mortgage approval amount:
Passing the Mortgage Stress Test
In Canada, debt-to-income ratio is used to determine if you can pass the mortgage stress test. Under the current regulations, borrowers have to qualify at the higher of two rates:
- Their mortgage rate +2 percentage points.
- The Bank of Canada’s benchmark rate.
For example, if you’re offered a mortgage rate of 5.5% and the Bank of Canada rate is 6%, you’ll need to qualify at 7.5%. If you’re offered 6 percent and the Bank of Canada rate is also 6%, you’ll have to qualify at 8%. Debt-to-income calculations for the mortgage stress test use the higher rate, not the rate you’re actually offered.
Debt-to-Income Ratio Is a Better Predictor of Mortgage Default
Lenders use historical data to estimate credit risk for new lenders. In the past, borrowers with higher debt ratios have been more likely to default, and borrowers with strong credit ratios rarely default even with lower credit scores.
Credit Scores Lag Behind Your Current Financial Situation
Credit scores reflect things like payment history, credit utilization, types of credit, and new credit report queries. They don’t reflect recently taken personal loans or car loans and other debt that you’ve recently assumed. DTI takes these new debt obligations into account, so they’re a better indicator of whether you can take on additional debt.
What to Do If Your Debt-To-Income Ratio Is Low
If your DTI (GDS/TDS) is borderline, you may still qualify for a mortgage from an alternative lender. However, if you want to qualify for a traditional mortgage, even small improvements can qualify you for better lender options or a larger mortgage. Here are some things to consider:
- Pay down credit cards and lines of credit.
- Avoid new loans and new credit cards.
- Increase your income if possible (Canadian lenders usually look for two years of consistent part-time income or self-employment income in addition to your regular income).
- Increase your down payment.
- Opt for a lower-priced home (think slightly outside your current preferred area or look for homes that need improvements).
Your debt-to-income ratio won’t sink your homeownership dreams, but you may have to spend time working toward them. Using GDS/TDS as a guideline and a good real estate agent in your corner, you’ll be in a home of your own before you know it!
