Definition: Debt ratios are key financial metrics lenders use to evaluate a borrower’s ability to manage monthly mortgage payments. These ratios help lenders determine the risk of approving a mortgage and ensure borrowers can sustain their financial obligations without overextending themselves. In Canada, the two primary debt ratios are the Gross Debt Service (GDS) ratio and the Total Debt Service (TDS) ratio.
Gross Debt Service (GDS) Ratio
The GDS ratio represents the percentage of a borrower’s gross monthly income allocated to housing expenses, including mortgage payments, property taxes, heating costs, and, if applicable, half of condo fees. This ratio ensures that borrowers are not spending too much of their income on housing alone, leaving room for other essential expenses.
Calculation:
GDS = (Mortgage Payment + Property Taxes + Heating + Condo Fees) ÷ Gross Monthly Income
Most lenders generally require a GDS ratio of 32% or lower, though borrowers with high credit scores or additional income sources may qualify with a slightly higher ratio. For example, a borrower earning $5,000 monthly with housing expenses totaling $1,600 would have a GDS ratio of 32% ($1,600 ÷ $5,000).
Total Debt Service (TDS) Ratio
The TDS ratio measures the portion of gross monthly income needed to cover all housing costs (as outlined in the GDS) plus additional debt obligations, such as car payments, credit card balances, and other loans. This ratio provides a more comprehensive picture of a borrower’s financial health by factoring in all recurring debts.
Calculation:
TDS = (Mortgage Payment + Property Taxes + Heating + Condo Fees + Other Monthly Debt Payments) ÷ Gross Monthly Income
Lenders typically look for a TDS ratio of 40% to 44% or less, though borrowers with strong financial profiles may be approved with a higher ratio. For instance, if the same borrower earning $5,000 monthly has total monthly obligations of $2,200 (housing costs and debts), their TDS ratio would be 44% ($2,200 ÷ $5,000).
Why debt ratios matter
Debt ratios are crucial because they provide lenders with a snapshot of a borrower’s financial health and their ability to manage mortgage payments. Lower ratios suggest a borrower is less financially stretched, increasing the likelihood of mortgage approval. High debt ratios, on the other hand, signal greater financial risk and may result in higher interest rates or even declined applications.
Maintaining healthy GDS and TDS ratios not only improves your chances of mortgage approval but also demonstrates financial discipline, which can lead to more favourable loan terms.
Tips for managing debt ratios
- Pay down existing debt: Reducing credit card balances or paying off loans can lower your TDS ratio, making you a more attractive borrower.
- Increase your income: A higher income naturally lowers both GDS and TDS ratios, improving your financial profile.
- Choose affordable housing options: Opting for a home within your budget ensures your GDS ratio remains manageable.
- Avoid taking on new debt: Limiting additional loans or credit cards can prevent your TDS ratio from exceeding lender thresholds.
Last modified: December 19, 2024
