Demystifying the economy | What is the impact of the “debt ratio” on a mortgage application?

Every Saturday, one of our journalists answers, in the company of experts, one of your questions on the economy, finances, markets, etc.

Mr. Villeneuve’s question concerning the eligibility standards for a mortgage loan is very relevant at the end of a year marked by the sharp increase in interest rates by the Bank of Canada, in order to curb inflation which has reached a record level in 40 years.

In fact, the vigorous rise in mortgage interest rates over the past year – in the range of 4% to 5% depending on the type of loan – is causing considerable financial stress among future mortgage borrowers, as well as those who are preparing to renew their loan.

“Borrowers will have to be patient, because retail interest rates will likely remain at historically high levels for several more quarters,” indicated Desjardins Group economists in their most recent “Interest rate forecasts” published in December.

And even if the recent fall in long-term bond yields allows us to anticipate a stabilization of interest rates, “it will probably be necessary to wait until later in 2023 before any declines are observed”.

In the meantime, point out the economists of Desjardins, “the context of recession could encourage financial institutions to be more cautious with regard to their policies for granting loans and credit”.

In other words, mortgage borrowers now face more demanding lenders in terms of financial qualification standards.

In this context, a better knowledge of the main eligibility criteria for a loan can prove to be an important asset in the preparation of a request for mortgage financing. Especially for a new loan for the purchase of a property, but also for an existing loan renewal with more expensive conditions and rates.

In their process of reviewing a mortgage loan application, lenders use two measures, or “ratios” in financial vocabulary, to determine the maximum loan amount a borrower is eligible for.

But instead of the “debt coverage ratio” to which Mr. Villeneuve refers in his question to The Presslenders actually use the “gross debt service ratio” and the “total debt service ratio”.

These two measures are also part of the standards established by the financial authorities in Canada, in particular the Canada Mortgage and Housing Corporation (CMHC). This federal crown corporation is the main provider of mortgage loan insurance in Canada for borrowers who have less than 25% equity in their home purchase.

The calculation of the ratios

How are these two measures of financial qualification of a mortgage borrower calculated?

First, the gross debt service ratio, or GDD in CMHC terminology, is based on the calculation of the total monthly amount of mortgage payments (principal and interest), property taxes and utilities (energy and heating), as well as half of the condominium fees if applicable.

Then the mortgage lender divides this total monthly amount by the sum of the loan applicant’s gross monthly income.

If the ratio resulting from this division does not exceed 32%, which is the first standard established by CMHC, the borrower then passes the first level of qualification for his mortgage loan application.

As for the second level of eligibility, it is the “total debt amortization ratio”, or TDA, with CMHC (also called “debt ratio” by analysts).

This ratio is based on a calculation similar to that of the ABD. But the lender adds monthly disbursements for debts already on the mortgage applicant’s personal balance sheet: car loan or lease, personal loan, line of credit, credit card balances, etc.

This total monthly amount of financial and land disbursements is then divided by the mortgage borrower’s gross monthly income.

If the ratio resulting from this division is less than 40%, which is the second standard established by CMHC, the borrower will then satisfy the second eligibility criterion for his mortgage application.

“Guiding standards”

As an additional question: what happens if the mortgage applicant fails at any of these financial qualification steps?

“If your ABD or ATD exceeds the standard issued by CMHC, you will need to consider increasing your down payment (on the purchase price of the coveted property) and paying off some of the other existing personal debts before submitting a new mortgage application,” reads the website of the firm ratehub.ca, which specializes in mortgage credit advice.

Furthermore, underlines ratehub.ca, “the maximum levels of 32% for ABD and 40% for ATD are guiding standards and not absolute rules”.

If a loan applicant has an already high credit rating, or already owns property and assets of significant value, they may qualify for a mortgage based on criteria unique to each lender.