If you have decided that buying a home is the right decision for you, then you are ready to take the next step; that is, determining what you can actually afford.
Let me start with a word of caution. Before you contemplate a mortgage for the full amount the lending institution indicates you are eligible, think it through carefully. For example, mortgage interest rates have been fairly low for the past couple of years. However, if you mortgage to the maximum amount allowed by the lending institution and interest rates have increased when it is time to renew your mortgage in five years, your mortgage payments may be higher as a result. If you are not on a strict budget, this may not be a problem but, if you are, you may have to make some sacrifices to carry those higher mortgage payments. Of course, in that amount of time, you may have paid down your principal and are starting to think about moving up in the Real Estate market.
So, what can you afford? For the most part, lending institutions look at two simple formulas when determining what you can afford for a residential mortgage. These two formulas are called the Gross Debt Service Ratio (GDS) and the Total Debt Service Ratio (TDS). Don't let the terms scare you off. They are quite easy to calculate!
Your GDS is 30% of your household's total gross monthly income. The 30% figure is what is normally considered reasonable for principal and interest payments on residential mortgages. Therefore, if your family's gross monthly income was $4,000 you would have $1200 available for principal and interest payments (30% of $4,000).
Take this one step further to calculate your TDS ratio. TDS also takes principal and interest payments into account, but it includes your property taxes and other fixed monthly expenses such as a vehicle or credit card payment. To calculate your TDS, take 40% of your gross monthly income. This amount is what is normally allowed for total debt servicing. For example, if you still have a $4,000 a month gross family income you can use $1600 for principal, interest, property taxes, and other debt servicing. In other words, if you had a monthly car payment of $250 and your monthly property taxes were $150, you would be able to use $1200 each month for mortgage principal and interest payments ($1600 - $250 - $150 = $1200). Keep in mind that these are general calculations and ratios. Some lenders may be more generous. Normally the lending institution will take the lesser of the GDS or TDS.
To put these examples in perspective in today's marketplace consider the following: a $100,000 mortgage at 7% amortized over 25 years would cost approximately $700 a month for principal and interest. Don't forget these calculations do not take into consideration the amount of money you have saved for a downpayment. So if you can afford to service a $100,000 mortgage and you are entitled to only put 5% down you can actually purchase in the $105,000 price range.
Note that the calculations and examples provided in this article are general in nature. Next we will discuss Investigating the Marketplace with a Qualified REALTOR®. Until then, keep educating yourself so you will be prepared to make the move to home ownership!
David Weir BA, CD is a Broker with Royal LePage ProAlliance Realty, Brokerage in Trenton. His sales in the Quinte area have ranked him in the Top 1% of all Royal LePage REALTORS® in Canada since 2005.