The Impact of car payments on mortgage qualification – Let’s review the numbers.
By Nick Holloway -
When we look at the overall debt obligations of Canadian households, we generallyfind the bulk of outstanding loan balances fall into the category of mortgage or vehicle payment. This article addresses specifically how vehicle loan payments restrict the debt servicing ability of the borrower in relation to mortgage qualification, and while other debt obligations such as credit cards or student debts apply to overall debt servicing, these items are outside of the scope of this piece.
To begin with a brief overview of the qualifying ratios used for mortgage qualification, these are worked out as a percentage of the applicants gross income. Firstly, there is the Gross Debt Ratio (GDR) which accounts for the expenses regarding the mortgage payment, property taxes and heat (plus 50% of Condo fee, if applicable). Secondly, the Total Debt Ratio (TDS), which accounts for the same line items as the GDR, but also includes all other debt obligations. In its simplest form, these ratios are calculated by summing all the relevant expenses together, then dividing by the gross income amount. It should be noted for the actual mortgage payment used in these calculations is determined by the current Bank of Canada Qualification Rate, at the time of writing is 4.79% or 2% above contract rate (whichever is higher), and not by your actual mortgage payment based on your contract rate. As a typical example of the ratios lenders require for qualifying a mortgage amount, most fall to a maximum of 39% for the GDR and a higher tolerance of 44% for the TDS, which we observe is a 5% difference (Ill come back to this later).
To look from the perspective of a first-time homebuyer who has no additional debts, the TDS and GDS ratios would be the same number, so we can determine the overall mortgage qualification is limited to no higher than a GDS of 39%. If the applicant were to add a car payment or other debt lines, this will result in an increase for the TDS ratio. To see this in practice, we accept an applicants annual income is at $120,000, which can be converted to $10,000 per month. For the GDS, lets assume the monthly expenses noted above total $3,900 per month, we calculate $3,900 divided by $10,000 equals 0.39 (39% written as a decimal). Now to work out the TDS ratio, we have to include additional monthly debt liabilities to the equation, so assuming the applicant has added a monthly vehicle payment in the amount of $500, then $3,900 plus $500 equals $4,400 divided by $10,000 results in 0.44 and is at our upper limit for the TDS ratio.
To optimise mortgage affordability, the applicant would ideally prefer to avoid triggering the TDS ratio as this may act to restrict the amount of the mortgage loan and property they wish to qualify for. To see the triggering of a TDS in practice as a continuation from the above example, if we adjust the monthly car payment up by $100 per month to $600, the resulting TDS ratio is increased to 0.45, or 45%, which is greater than the TDS threshold by 1%. The resulting difference in affordability means a reduction of around 3% less mortgage which the applicant can qualify for based on the same income level.
In conclusion, it is important to understand how the debt servicing translate to mortgage affordability and take consideration as to how best to optimise this. Assuming it is necessary to add a vehicle payment, a simple rule of thumb is considering limiting the amount of your monthly vehicle payment to less than 5% of your gross monthly income (i.e. Gross monthly income x 5%), or if it is possible to adjust the timing of a vehicle loan until after you have completed on your home purchase and associated mortgage funding, this will assist with minimizing your TDS ratios accordingly. If you have any questions regarding taking on new debt obligations, it is recommended you consult in advance with your mortgage professional so they can best advise based on your specific circumstances and help with aligning to your long term goals accordingly.
Saving for a 20% down-payment or buying now – Lets review the numbers
By Nick Holloway -
As a mortgage professional, a question which comes up regularly is whether a borrower should wait to purchase a property until they have a down payment of 20% or more. As with most mortgages in Canada, it is necessary for the borrower to pay a mortgage default insurance premium as a percentage of the mortgage funds borrowed to either CMHC, Genworth, or Canada Guaranty when the down-payment is less than 20%. When the down-payment is greater than 20%, the borrower is generally not required to pay the mortgage default insurance premium. This question requires a closer examination of the numbers so a borrower can make an informed decision as to which best suits their needs, so I want to explore a couple of different scenarios to aid in this decision-making process.
Firstly, we need to understand what our two scenarios are to consider, and for the purposes of this illustration, the borrower can qualify in both cases based on their current and future income and debt levels. They are looking for a property of around $500,000 which will suit their specific needs and lifestyle. The initial scenario is they currently have a sufficient cash resource to cover a 5% down payment with the associated closing costs and are looking to purchase straight away. The alternative scenario is the client is intending to take the next 3 years to save for the additional down-payment to make up the balance of the 20% down payment to avoid the mortgage default insurance, they will continue to rent in the meantime. We are to assume the house-prices and a fixed rate of 3% compounded semi-annually with a 25-year repayment schedule will remain the same in both scenarios to remove variable considerations from the model.
Scenario one Buy the house now
The client finds their ideal property for $500,000 and they are to apply the 5% down-payment would result with a $475,000 balance to mortgage. As the borrower is required to apply a mortgage default insurance premium of 4% of the mortgage balance, this equals $19,000 which is applied to the principal of the mortgage loan for a total of $494,000. It should be noted the insurance premium requires the amount of provincial sales tax (PST) has to be added to the closing costs which cannot be added to the mortgage amount. In this case, we want to understand the break even point of paying down the $19,000 insurance balance based on the principal and interest payments being made towards the overall loan. To look at the first monthly mortgage payment which is set one month after taking possession of the property, we calculate this as a total of $2,337.83 which is made up of $1,110.48 as principal and $1,227.35 as interest. The outstanding principal is now at $492,889.52 after one month. If we move along the repayment schedule to the completion of the 17th monthly payment, we can see the new principal balance is $474,741.89. At this point, we have broken even on paying down the excess mortgage insurance balance. At the end of the first 3 years, the mortgage principal balance is now reduced to $452,234.53.
Scenario two Buy the house later
The client has successfully increased their savings over the last 3 years by an additional $50,000 to make the balance for their 20% down payment of $100,000, or an equivalent increase of savings per month of $1,388.88 over 36 months. The closing costs to purchase their ideal property of $500,000 are broadly in line with the first scenario based on the same purchase price (apart from the PST mentioned above), but the initial mortgage amount is $400,000 with the absence of a mortgage premium. They opt for 25 years and the lower monthly payment is $1,892.98, however they are also going to take a longer time to repay than scenario one so they want to see if they can align the repayment schedule to 22 years to match the same maturity, the payment increases to $2,067.81 in this scenario.
As you can see from the above guide, we are isolatingonly one item of the overall considerationfor homeownership against alternative shelter options and associated costs. We are not looking at comparable rents available in the market, nor items such as property appreciation, property taxes or maintenance for the homeowner which may change these outcomes. We also have to consider the discipline required to save the additional down payment in scenario two whilst still having shelter costs of rent in the meantime, whereas scenario one may have an excess savings rate they could apply to accelerate their mortgage principal repayments asthey may not have rental payments to consider. The decision for home ownership is a personal choice and should be taken as a combination of many different factors. I trust the above guide helps with looking at one ofthesefactors to assist withthe overall decision making process.
Mortgage repayment schedules and payment deferrals options – Explained
By Nick Holloway -
When borrowers are assessing their mortgage options with a mortgage professional, one consideration is how long the borrower will need to repay the mortgage loan. This repayment schedule is referred to as an amortization of loan, which spreads the repayment of principal and interest payments over multiple periods until the principal loan amount is reduced to zero. In most instances, mortgages are offered with a 25-year amortization, although this can be made longer or shorter depending on the options available for the specific mortgage product. It is important to differentiate the amortization period from the term of the mortgage, which in Canada is most commonly over a 5 year term, after which time the borrower will be required to renew into a new term or move lenders in order to continue with the amortization of the remaining principal balance.
How are my mortgage payments determined?
The borrower is provided with options to repay the mortgage weekly, bi-weekly or monthly. For ease of example, I will focus on a monthly payment over a 25-year repayment period. Given a 5-year term of the loan, we can determine the borrower will make 60 monthly repayments of principal and interest payments over the period. Assuming an initial principal amount is advanced on the first day of a given month and totals $400,000 with a fixed rate of 3% compounded semi-annually, the first scheduled payment will be due one calendar month following the advancement of the loan, calculated on the principal outstanding amount of $400,000. The payment would total $1,892.98 and is broken down into a principal amount of $899.18 and interest amount of $993.81, which results in a lower principal amount of $399,100.82. For the second monthly payment, the interest component is calculated on this lower principal amount, so while the payment amount of $1,892.98 remains unchanged, the principal amount is increased to $901.41, with the corresponding interest amount reducing by $2.24 to the amount of $991.57. If we fast forward to the 60th payment at the end of the 5-year term, the proportion paid to principal has increased to $1,040.94, while the interest portion is reduced to $852.04, with an outstanding principal balance of $341,898.42. We can determine in this case that principal has been reduced by $58,101.58, or alternatively by 14.53% from the original $400,000 balance. The interest paid over the corresponding period totals $55,477.34.
What if I were to defer my mortgage payment, what happens then?
If a borrower needs to defer their mortgage payment to manage their immediate cash-flow requirements, this results in no principal and interest payments are applied to the loan balance at the scheduled payment date(s). The interest is still accruing on the loan however, so it should be expected that on the scheduled payment dates, interest continues to be applied to the loan balance in a similar way to a credit card or line of credit balance would, which results in an increase in the principal amount until a time that principal and interest payments are able to be resumed. To refer back to our original example with the balance at $400,000 and assuming the deferral is made at this point, we should expect the new mortgage balance will increase by $993.81 to equal $400,993.81, in effect this is similar to the above amortization schedule but working in reverse. For the following month, the interest on the new balance increases by $2.47 to $996.28, and assuming this is continued for a 6-month period, the new interest totals $6,000 and resulting principal mortgage balance equals $406,000. The borrowers defined benefit is an increase in cash flow of $11,357.88 realized over the 6-month period which they otherwise would have been putting towards their mortgage payments according to my initial example. If we are to capitalize this interest to the mortgage principal, we want to work out the new mortgage amount going forward. If we assume the repayment is calculated over the same 25-year period, the new payment amount equals $1,921.38, or alternatively if this were calculated over a twenty four and a half year basis, the new payment equals $1,947.81. The increases from the original payment amount of $1,892.98 is $28.40 or $54.83 respectively.
What should I do next?
In summary, it is important to understand the costs and benefits of deferring your mortgage. If there is an immediate need to increase cash flow to replace a loss of earnings given the current Covid-19 situation, the flexibility of being able to apply to your lender for a mortgage payment deferral will likely come at a substantially lower interest rate when compared to unsecured borrowing options such as through credit cards or lines of credit. The payment deferral provides temporary relief, and it is with anticipation that earning potential will improve following the initial shock and the economy begins to function normally again once restrictions on physical distancing are able to be lifted. Should there be an opportunity in the future to increase your mortgage repayments to reduce your overall interest costs, this can be achieved by utilizing the pre-payment features offered with your mortgage.