Can you afford that new home?
Out-of-sight prices aren’t all you have to contend with
Home buyers in Canada are faced with a seemingly impossible market, especially for younger first-time buyers. Lack of supply, inflation, and rising interest rates have pushed up prices and made house hunting a challenge this year. The Teranet-National Bank Composite House Price Index, which covers the country’s 11 largest markets, rose by 1.8% from June to July, the fifth consecutive monthly increase. In the 12 months, the index fell by 1.9%, from July 2022 to July 2023, but that’s cold comfort for those looking to buy a house now.
So what rule of thumb can you use to calculate the type of house you can really afford? There’s no simple one-size-fits-all answer to this question. But as a starting point, you have to determine how much mortgage debt you can afford to carry. Because that’s what mortgage lenders will look at. And they’ll apply some pretty rigorous screens to determine it.
The Canada Mortgage and Housing Corporation recommends following two affordability rules to determine how much you can spend on your home without breaking your budget.
- Monthly housing costs should be no more than 32% of your average pre-tax monthly income. This percentage is known as your gross debt-to-income or gross debt service (GDS) ratio. CMHC restricts GDS ratio at 39% to qualify for an insured mortgage.
- Your monthly total debt load (which includes credit card interest, consumer loans, and car payments, and housing costs) should be no more than 40% of your average pre-tax monthly income. This percentage is known as your total debt-to-income or total debt service (TDS) ratio. CMHC restricts total debt service (TDS) ratio at 44% to qualify for an insured mortgage.
The Gross Debt Service ratio and Total Debt Service ratio are calculated using factors such as your annual income, overall debt load, and how much you pay every month for housing costs.
To make matters even more complicated, anyone borrowing from a lender subject to federal regulation (and that includes just about every financial institution in Canada) will have to pass the OSFI Mortgage Stress Test in order to be approved for a mortgage. And note, this applies to all borrowers, including those making down payments of 20% or more, who typically don’t need mortgage insurance.
Applied to the loan application, the stress test will look at such things as how much you’ll be able to afford with your current debt-to-income ratio, and whether you’d be able to continue making payments if interest rates rise or you lose your job. But the kicker is that even if you qualify for a mortgage at a current contracted rate today, you’d still have to qualify for a mortgage at an even higher rate.
According to the Financial Consumer Agency of Canada (FCAC), banks must use the higher interest rate of either 5.25% or the interest rate you negotiate with your lender plus 2%
If you already have a mortgage, you’ll need to pass this stress test if you refinance your home, switch to a new lender, or take out a home equity line of credit. Check the online stress test calculator at the FCAC to see if you qualify. But don’t rely on this alone. Your mortgage lender will be able to give you a better idea of whether you actually qualify for a mortgage or not, and offer alternatives.
Working from these ratios, you’ll be able to determine how much mortgage you can afford to carry. Most younger couples just starting out will not be able to afford a single-standing home in the downtown areas of larger urban centres. At least not without stretching their budget to the breaking point. In addition, you’ll have to budget for monthly maintenance and upkeep costs of your home – costs that were buried in your monthly rental payment, but which will now come out of your own pocket – in addition to your mortgage payment.
The CMHC also reminds home buyers not to overlook the upfront cash outlay needed to cover a host of fees, expenses, and taxes, known as closing costs, before you ever even set foot in your new home. These include such items as
- the down payment
- home inspection and appraisal fees
- insurance costs
- land registration fees
- land transfer taxes if applicable
- prepaid property taxes or utility bills (the buyer reimburses the seller or builder)
- legal or notary fees
- potential repairs or renovations
- moving costs
- GST/HST/QST on a newly built house or mortgage loan insurance
So how do you cut the cost of buying a home? First, make as big a down payment as you can. Borrowing a smaller amount means paying less interest over the term of the mortgage, which can add up to tens of thousands of dollars in savings. Another way is to set up weekly payments on your mortgage. This means that more of your payment is quickly applied to the principal. Take advantage of any annual principal prepayment options, which allows you to make specified annual lump-sum payments directly against the principal amount. Again, cutting the principal is important, because you’ll be paying off your debt faster and reducing your interest costs considerably.
The offset to the tidal wave of costs involved in buying and owning your own home is that property values tend to increase over the longer term, at least by the rate of inflation, and often by quite a bit more depending on the location of your home. And with every principal payment, you’ll be adding to your equity, which means that each month, the bank owns less and you own more of your home.
Buying your first home is a big decision. If you’re having trouble deciding, consult a qualified financial advisor to help bring you back to earth and decide what’s really affordable for you.
Robyn Thompson, CFP, CIM, FCSI, is the founder of Castlemark Wealth Management, financial mentor, and keynote speaker. Find Robyn at her new website Robyn Thompson Money.
Notes and Disclaimer
Content copyright © 2023 by Robyn K. Thompson. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited.
The foregoing is for general information purposes only and is the opinion of the writer. Securities mentioned are illustrative only and carry risk of loss. No guarantee of investment performance is made or implied. It is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. Please contact the author to discuss your particular circumstances.