It’s hard to find a story on real estate these days that doesn’t bring up housing affordability. We’re constantly reminded that the average home in Toronto and Vancouver sells for over $1 million. If I was a first-time homebuyer, I’d feel like homeownership is impossible.
The good news is that couldn’t be further from the truth. The homeownership dream is still alive and well. While a detached house in the downtown core may be outside your price range, you can probably swing a condo or townhouse in surrounding areas. It’s all about compromise.
Falling Mortgage Rates Help Keep Real Estate Affordable
The Huffington Post recently wrote an article about how it takes twice as long to save up for a house as it did 15 years ago. According to a survey from Mortgage Professionals Canada, it takes an average of 102 weeks to save up a 20 percent down payment, about double the number of weeks it took 15 years ago.
At first glance it would seem housing affordability has eroded considerably in the last decade and a half. In fact, it’s mentioned that home affordability has reached its worst levels in Toronto in more than 20 years.
With home prices rising a lot faster than incomes, what’s keeping the average homebuyer in the market? Falling mortgages rates; they’ve helped keep monthly mortgage payments affordable (the lower the mortgage rate, the more house you can afford).
The Bank of Mom and Dad
The Bank of Mom and Dad is also playing a significant role. Way back in 1990, only five percent of parents helped their adult kids with their down payment. Since then, it’s tripled to 15 percent. (This is in line with a BMO survey earlier this year that found two-thirds of millennials plan borrow from family to buy a home.)
Many boomers have made a boon off real estate and are looking to help out their millennial kids through living inheritance. They don’t want to see their offspring struggle like they did growing up. Instead of buying a starter home, they want to see their kids have it all – granite countertops, stainless steel appliances and hardwood floors. This only encourages first-time homebuyers to spend more on housing than they would have otherwise.
We Love Buying Big Homes
While there’s no denying that houses are a lot more expensive in Toronto and Vancouver than 15 years ago, what the article fails to mention is that we’re buying larger homes. It may take twice as long to save for the average home, but that’s because the average home is a lot bigger these days.
While taking on a massive mortgage may be more affordable when mortgage rates at low, what happens if and when rates rise? Could you afford to pay an extra $50 or $100 per month toward your mortgage? If the answer is no, then chances are you’re buying too much house.
Although the new mortgage rules help protect us from buying too much house, it’s still important to crunch the numbers and see how much you’re comfortable spending on a home. Just because the bank lets you spend $800K, doesn’t mean you should spend that much. You still need money left over for emergency savings, not to mention to have fun.
Debt Ratios: How Much Home Can You Afford?
When it comes to qualifying for a mortgage, lenders care about four main factors: your income, down payment, credit and debt ratios. (I discuss these in my upcoming book, Burn Your Mortgage.) Lenders use debt ratios to determine how much you can afford to spend on a home. There are two debt ratios lenders use for qualifying homebuyers: gross debt service ratio and total debt service ratio.
Gross Debt Service Ratio
The gross debt service (GDS) ratio looks at the portion of your gross monthly income needed to cover your monthly housing costs (e.g., mortgage payment, property tax, heating and 50% of maintenance fees). Most lenders in Canada are looking for a ratio of 35% or below, although if you have a credit score over 680, some lenders let you go as high as 39%. To avoid being house rich, cash poor, aim for a GDS ratio 30% or below (up to 35% in pricey real estate markets).
For example, if you have a mortgage payment of $1,300, property taxes of $250, heating bill of $75 and gross income of $5,600 per month, your GDS would be:
GDS = ($1,300 + $250 + $75) / $5,600 x 100 = 29.02%
Since your GDS ratio is below 35 percent, you’ve passed the first debt ratio hurdle.
Total Debt Service Ratio
The total debt service (TDS) ratio takes the gross debt service ratio a step further. It looks at the portion of your gross monthly income needed to cover your monthly housing costs, plus monthly debt payments (e.g., car loan, credit card debt, line of credit, student loan). Most lenders in Canada are looking for a ratio of 42% or below, although if you have a credit score over 680, some lenders let you go as high as 44%. Aim for a TDS ratio of 37% or below (up to 42% in high-cost cities).
Using the same example above, let’s say you also had a car payment of $200 per month. In that case, your TDS would be:
TDS = ($1,300 + $250 + $75 + $200) / $5,600 x 100 = 32.59%
Since your TDS ratio is well below 42 percent, you’ve passed the second debt ratio hurdle.
Just because you have a debt ratio a lot lower than the maximum, doesn’t mean you should go out and buy the biggest house you can. You’ll want to leave yourself some financial wiggle room in case, for instance, you lose your job, you decide to start a family (debt ratios don’t take daycare costs into account) or mortgage rates go up. If you’re anything like me, you’ll sleep a lot better at night knowing you’re protected if any of these things happen, not to mention you can burn your mortgage years sooner and enjoy financial freedom.