Everyone dreams of owning their own home, but for many people, the financial requirements can seem insurmountable. While a home won’t ever be cheap, it might not be as bad as you think.
If you plan on buying a home in the near future, you will need to take a careful inventory of your financial condition. There are numerous factors that affect how mortgage lenders will feel about lending to you, and what mortgage amount you will be able to afford.
In this article, we are going to cover everything you need to think about before looking for a home of your own. We will also offer some tips to help you get the most affordable mortgage available.
The general answer
The conventional answer to the question, “How much mortgage can I afford?” is that you should aim for a purchase price that is 2 – 4x your annual income. For example, if your household makes $120,000 a year, you could afford a maximum purchase price of $480,000.
However, in recent years, home prices have shot up faster than Canadian incomes could keep up, meaning that this formula may not be so accurate anymore. In 2020, Canadian home buyers’ average income-to-value ratio was closer to 7x the household’s income. Are these mortgages actually affordable? It’s hard to say.
Most banks and lenders now offer online mortgage calculators to help give you a ballpark idea of what you can afford. These are a good place to start.
Terms to know and how they affect affordability
Your mortgages affordability can be best understood through the amount of your monthly mortgage payments. Since you don’t pay your loan all at once, it’s best to think about it as a series of smaller payments. Banks will determine your mortgage options based on how much of a mortgage payment you can afford with a given purchase price, interest rate, amortization period, and monthly income.
Gross vs Net Household Income
One of the biggest factors in determining how much mortgage you can afford will come down to how much money you actually have for your monthly payment. There are two major terms to know here: gross household income and net household income.
Your gross household income is the amount of income your household takes in before any taxes, debt payments, or other obligations.
Your Net household income represents the amount of income you have after paying for taxes, bills, and debt payments.
Once banks know your income, they are able to calculate your debt service ratios.
Gross Debt Service Ratio
The gross debt service ratio (GDS) is the ratio between your annual housing expenses and your income. Your annual housing costs include the sum of your monthly mortgage payments, mortgage insurance fees, property insurance fees, property taxes, and utilities such as heating costs. In a condo, your condo fees may count towards your GDS.
In general, banks will not offer you a monthly mortgage payment that would comprise more than 32% of your gross income. In some rare cases, you may be able to go as high as 39% GDS.
Total Debt Service
Your total debt service ratio (TDS) is the ratio between your gross income and all of your expenses. This includes aforementioned shelter costs and other things such as household expenses, student loans payments, car loans, and credit card bills. In general, banks will borrow at a TDS of 40%, with a maximum of up to 44% in some cases.
Your credit score also plays a major part in calculating what size of loan you can afford. Banks need to feel confident that their loan will be profitable, so they favour people with the best credit histories. In general, Canadians with excellent credit scores (~680 and up) will get the best rates from their lender. Therefore, they will be able to afford more on their mortgage.
Your down payment
Saving up enough money for your down payment can be one of the biggest barriers to getting a mortgage loan. Having too low of a down payment can cost you more in insurance costs and high rates. In comparison, having a larger down payment will give you the best mortgages available.
On a home of $500,000 or less, you will need to put up a minimum of 5%, and on homes worth more than $1 million you will need at least 20% down.
These days, more Canadians are relying on gifts from their families to pay for much if not all of their down payments. Unfortunately, this is not an option for most Canadians. You will need to practice careful saving before you even approach the idea of getting a mortgage.
Mortgage default insurance
If your down payment is less than 20% of the value of your home, you will be required to pay for mortgage insurance. Mortgage insurance can cost you up to 4% of the value of your mortgage.
The amortization period is the length of time it will take for your mortgage to be fully paid off. A longer period means more affordable monthly payments, but it also means you will pay more in interest in the long run.
Mortgage Stress Test
The mortgage stress test is a measure introduced to ensure that Canadians can still afford their mortgage loans if interest rates increase. The mortgage stress test will test your income against an interest rate higher than your actual mortgage rate.
The testing rate is 5.25% or your interest rate plus 2%, whichever is higher. All banks will require this test on all mortgages, even those not needing mortgage insurance.
Tips to make your mortgage more affordable
Pay a large down payment
A higher down payment will help you get a more affordable loan. If you are set on a certain mortgage amount, consider saving for a few extra years to raise your down payment. Alternatively, you could seek out additional sources of income to increase the amount that you can afford to save.
One option available to first-time homebuyers is the Home Buyers’ Plan. This incentive allows first-time buyers to withdraw up to $35,000 from their RRSP, tax-free, to put towards a down payment. If you are buying with a partner, you can collect up to $70,000 in total. But be warned, this is essentially a loan from your future self; after a 2 year grace period, you will need to repay any amount you take out in 15 years. It is up to you to decide on getting money for your home now against saving for retirement later.
Improve your credit score
Improving your low credit score can do a lot to help your mortgage affordability. It will also put you in a much better financial spot generally.
There are a few different ways that your credit score is determined. There are also some easy ways that you can begin improving your score. See our recent credit score guide for more in-depth information.
Pay down debts
Paying down your debts will free up more of your monthly budget to go towards your mortgage. If you spend less on monthly debt payments, those savings can go towards your down payment.
Adjust your lifestyle
For some people, the idea of owning a home is the dream. That being said, you may need to consider moving towards a more frugal lifestyle in pursuit of your dream. If you are willing to reduce your monthly expenses for the joys of homeownership, it can do a lot to make your mortgage more affordable.
You may have your heart set on a certain neighbourhood or town, but prices can be very different in different areas. Consider looking at more affordable areas near where you want to live, and you may find a deal that changes your mind.
It’s important to think beyond the purchase price—municipalities all have different property tax rates. Keep this in mind because a cheaper home in a different location can end up costing more after you pay property taxes.
Hopefully, you now have a better idea of the maximum mortgage you can afford. If you feel ready to start your journey, talk to a mortgage specialist or mortgage broker who can help you find the price that is right for you.