Knowing what mortgage you can afford is one of the most important questions you can answer before you start looking at real estate listings and talking with a realtor. Mortgage affordability can help determine where you live as well as what type of home you might live in (condo, duplex, detached, etc).
There are several important factors that come into play when figuring out what mortgage you can afford. Let's take a look at these.
Mortgage affordability is the term used to describe what mortgage you can afford. This refers to how much you're able to borrow based on your annual income, what kind of debt you have and what other expenses you have. Simply put, the higher your mortgage affordability, the more "house" you can afford.
Affordability also has to do with the overall housing market of a larger geographical area. For example, affordability in rural Ontario is a lot higher than downtown Toronto or Vancouver. The housing market in large urban areas requires a very high level of income making those areas less affordable for the average person. This use of the term "affordability" is slightly different from what you can afford based on your cash flow, but it's an important factor to consider as you take on a mortgage.
The size of your mortgage is largely dependent on your income. Income can be derived from you as an individual, but you can also list a co-applicant when you are applying for a mortgage. Typically, the higher your income, the more you are able to afford. This is subject to the general affordability of the location in which you live as we've mentioned.
Another large factor in knowing what mortgage you can afford is the amount of debt you have. Whether it's college debt, vehicle payments or credit card debt, all of these are significant factors when it comes to applying for a mortgage. Debt obviously works against you when it comes to mortgage affordability as a lender may be hesitant to give money to someone who is already deep in debt.
One other factor to consider is what your regular living expenses add up to. Living expenses like utilities, housing expenses and property taxes are factored into the equation when it comes to determining what mortgage you can afford.
There are a couple basic ways that mortgage affordability is calculated. One rule of thumb is that you can afford a mortgage where your housing costs are less than 32% of your gross household income. This rule of thumb is set out by the Canadian Mortgage and Housing Corporation (CMHC). Housing costs include mortgage principal and interest amounts, property taxes and heating expenses. The cost of these expenses combined should not exceed 32% of your gross monthly income. This ratio is often referred to as the Gross Debt Service Ratio (GDS Ratio).
An alternative rule of thumb, also developed by the CMHC, is that your total debt load including housing costs should not exceed 40% of your gross household income. This would mean that your housing expenses plus car payments and other loans should be less than 40% of your gross monthly income. This ratio is often referred to as the Total Debt Service Ratio (TDS Ratio).
While these percentages are a general guideline provided by the CMHC, new limits for GDS and TDS ratios respectively are 35% and 44%.
Another big factor that determines mortgage affordability is the size of your down payment. There are a couple different formulas that are used to calculate affordability in this area too.
If the down payment on your home is going to be less than $25,000, the maximum purchase price you can afford can be calculated this way.
Down Payment Amount / 5% = Maximum Affordability
If the down payment on your home is going to be greater than $25,000, the maximum purchase price you can afford is calculated this way.
(Down Payment Amount - $25,000) / 10% = Maximum Affordability
On top of assessing debt service ratios and down payment amounts, mortgage affordability also includes having additional cash on hand for things like closing costs.
Closing costs typically range from 1.5-4% of the value of your home at the point of selling. Depending on where and what home you purchase, this can be a notable amount of money.
These formulas and calculations are a great place to start when determining mortgage affordability, but chatting with a mortgage broker about real numbers is the best path forward. A licensed broker can easily show you what you are pre-approved for which gives you the best home buying experience.