How much house can you afford?

Dream home or money pit?

Q – We’re expecting our first child next spring, but we currently live in a one-bedroom condo in downtown Toronto. We’re thinking about finding a larger space, probably a townhome just outside the city. But we’re not sure how much mortgage we can afford, given that house prices in the Greater Toronto Area are sky high. Are there any tips for calculating affordability? – Richard P., Toronto, Ontario

A – The big question for young couples just starting out is whether to move out of that downtown condo unit and borrow to buy a home. This becomes especially critical if you’re planning a family or if a baby is already on the way. Those new little people with all their gear take up and amazing amount of space, and suddenly the need for more room becomes pressing.

So what rule of thumb can you use to calculate the type of house you can afford so you don’t fall into the proverbial “money pit”? There’s not really a 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.

When you apply for a mortgage, your bank or other lender will look at something called the Gross Debt Service (GDS) ratio and Total Debt Service (TDS) ratio. These are calculated using factors such as your annual income, overall debt load, and how much you pay every month for housing costs.

The Canada Mortgage and Housing Corporation (CMHC), which governs the mortgage market in Canada has a rule that your monthly housing expense – which is the total of your mortgage principal and interest, tax, and heating expenses – can be no more than 35% of your gross household monthly income. This is your gross debt service (GDS) ratio. Your GDS is the ratio of your total housing costs to your gross monthly income.

In addition, the CMHC rules state that your total monthly debt load (which includes credit card interest, consumer loans, and car payments), including housing costs, can be no more than 42% of your gross monthly income. Your TDS is the ratio of your total of your monthly debt load to your gross household income.

To make matters even more complicated, as of Jan. 1 this year, 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 now 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, which is calculated as your current rate plus two percentage points, or the average posted 5-year bank rate, whichever is higher.

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.

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 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.

Don’t forget that there are numerous closing costs involved with real estate transactions, including legal fees. These can soar to several thousand dollars depending on the size of your purchase. Try to find out in advance how much these will be, from your real estate agent or lawyer, and make sure to budget for these so you don’t get caught short.

Buying your first home is a big decision. If you’re having trouble deciding, a qualified fee-for-service financial advisor can always 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, a boutique financial advisory firm specializing in wealth management for high net worth individuals and families. Contact her directly by phone at 416-828-7159, or by email at rthompson@castlemarkwealth.com for a confidential planning consultation.

Notes and Disclaimer

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.