If you’ve ever wondered about what happens with your mortgage application behind-the-scenes, how financial institutions calculate how much money you can borrow, we’re here to demystify the mortgage math for you.
We all know buying a home is likely the largest financial commitment you’ll make in life, so understanding how banks calculate your mortgage is a great way to stay educated throughout the process. There are five pillars of mortgage lending used your determine your creditworthiness and ability to repay the loan: Credit Score, Down Payment, Gross Income, Liabilities, and Servicing Ratios. We’re going to cover the math behind the servicing ratios – the magic numbers that determine how much you can afford and how much of a mortgage you can carry.
Let’s get into into it:
The servicing ratios depends on 2 things: your income and the amount of debt you’re carrying. Financial institutions use two different servicing ratios to determine your borrowing ability and capacity in which you can repay your loan. The first is your Gross Debt Service Ratio (GDSR). The second is your Total Debt Service Ratio (TDSR).
GDSR = percentage of your gross income required to cover home-related costs (mortgage payment, heat, taxes, condo fees). Usually, lenders use 39% of your gross income to calculate affordability.
TDSR = percentage of your gross income required to cover home-related costs PLUS all your other debts (student loans, cars payment, credit cards, etc.). Usually, lenders use 44% to calculate affordability.
How the calculations work:
As mentioned above, your mortgage approval takes into account the amount of your down payment, gross income, credit score, and all outstanding debts. When banks look at your application, they are taking all factors into account while asking the main question: How much new debt (the mortgage) can be taken on while still maintaining the ability to repay all existing debt?
Let’s say your gross monthly income is $5,000
The GDSR must be less than 39%, therefore, your maximum allowable monthly payment is: $1950
Hold that thought. Now let’s say you make a monthly $400 car payment and a $200 student loan payment.
Here’s where the TDSR calculation comes in:
Take 44% of your monthly income ($5000) = $2200
Now subtract the $400 car payment and $200 student loan payment from $2200 = $1600
The maximum monthly payment you could qualify for is $1600 because 1600 is less than 1950.
The reason the lesser value is chosen as your maximum allowable monthly payment because a lender wants to make sure you can meet all debt obligations before approving your mortgage payments.
What does this all mean?
Remember, the complete picture of your financial situation and credit worthiness is taken into consideration when applying for your mortgage, so it’s important to keep all of the factors in mind when you start the mortgage loan process. Understanding how outstanding debts like car payments and student loans drastically reduce your ability to borrow is important when trying to get pre-approved. Paying down these debts and/or increasing your monthly income, will allow you to increase the mortgage amount you can qualify for. And if you’re not exactly where you’d like to be, you can use this simple mortgage math to work towards your home ownership goals.