While researching everything there is to know about mortgages, you may have come across the concept of the debt service ratio (DSR). Debt service ratio is one of those fun financial terms that is often thrown around with no real explanation of what it means. Fear not, because debt service ratios are actually not that hard to get your head around.

It is important that you understand what your ratios are and how to calculate them because they are useful indicators of your financial condition. They are also an important indicator that a lender will use to determine the terms of your mortgage loan and are an important factor in the mortgage stress test. This is a must for anyone looking to buy a house.

What is a debt service ratio?

Debt service ratio is essentially the ratio of your income to your debt payments. This ratio is important because it provides an easy 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 20% ratio means that your annual debt payments make up 20% of your annual gross income.

It’s worth remembering that your debt ratios are calculated based on your gross income, that is, income before deductions and taxes. That means the percentage of your gross income that you want to spend on housing might be 20%, but in terms of actual disposable income, it will represent a larger percentage of your available resources.

What are the types of service ratios?

Your debt-to-GDP ratio isn’t actually a single number. Rather, there are two main types of ratios, the gross debt service ratio (GDS) and the total debt service ratio (TDS). These measures are similar but have minor differences that make them useful in different situations.

Gross Debt Service Ratio (GDS)

Your gross debt service ratio shows the ratio between your housing costs and your gross income. Housing costs consist of your mortgage payments, as well as monthly property taxes, heating bills, half of your condo fee if applicable, and any other housing-related costs.

To calculate your gross debt service ratio for a home you don’t yet own, you need to make estimates for the various numbers. Once you have your estimates, simply divide them by your monthly gross (before taxes) 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 kind of debt payments you can afford with your income.

Total Debt Service Ratio (TDS)

Your total debt service ratio represents the ratio of all your monthly debt payments, including housing, to your gross income. In addition to housing costs from above, your total debt service ratio also takes into account any monthly debt payments you may have, such as credit card bills, car payments, lines of credit, and more.

The calculation for total debt service is essentially the same as for the gross debt service ratio once you include all additional debt payments.

Does rental income count toward debt repayment ratios?

If you already have rental income and are looking for another home, 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 may count up to 50% of the potential gross rental income from the property as income when calculating your debt service ratios. The only exception is if you plan to live in one of the units of a multi-unit rental property as your primary residence. In that case, you may include 100% of the gross rental income in your ratios.

Why do debt service ratios matter?

Debt service ratio is most important as it will play a role in determining your mortgage. Of course, there is an upper limit to the monthly mortgage payments you can afford based on your monthly income. Mortgage lenders, however, will not let you spread too thin.

The Canada Mortgage and Housing Corporation (CMHC) sets limits on how high the debt-to-GDP ratio can be to qualify for a mortgage loan. Similar to the mortgage stress test, the idea behind this choice is to prevent borrowers from taking on mortgages they can’t afford. The CMHC also sets a debt ratio limit for borrowers seeking mortgage default insurance.

If your debt-to-GDP ratio is too high, you’ll need to lower it below the ceilings to qualify for a mortgage. Otherwise, you must borrow from a private lender that does not adhere to 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 cap of 44%, although most banks prefer that a borrower stays below 42% for mortgages.

How can I improve my debt service ratio?

If your debt-to-GDP ratio is too high to qualify for a mortgage, you need to find a way to lower it.

Because your GDS is often based on a hypothetical home you want to buy, it’s easiest to lower. Essentially, you need to change the mortgage terms or find another home. With a longer depreciation period or a cheaper home, you can pay a lower monthly mortgage and free up space in your GDS.

Lowering your TDS is a bit more difficult because one of the main ways to lower it would be to pay off debt. Of course, everyone wants to pay off their debts as quickly as is reasonable, but there isn’t always a way to speed up this process. One thing you may be able to change is increase your income by changing jobs or finding alternative sources of income. Again, this isn’t always in your control, but it’s a good option if you can make it work.

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