For this month, we will be continuing to take a look at the “five Cs of credit”. To refresh your memories, the five Cs include credit, capacity (ability to make the payments), capital (down payment), character (length of employment, savings history and other factors that supplement credit history) and collateral (assets owned in addition to down payment). Last month, we took a look at what lenders look at when reviewing credit. This month we will be talking about capacity, the ability to make loan payments.
On a broad level, capacity is quite simple. It is basically the borrower’s ability to make the payments on their loans. This is generally done by looking at the percentage of your income that is used up to make these payments. The two main things that can vary here is what percentage of your income a lender will allow, and what can be used as “income”.
For mortgage lending, the rule of thumb is 32 per cent of your gross income can be used towards your mortgage payment, property taxes and heating. This is called your gross debt service ratio (GDS). The percentage that can be used for total debts (total debt service ratio or TDS) is generally 40 per cent. TDS includes all payments, such as car loans, credit cards and lines of credit. So very simply, if you make $100,000 a year you can spend up to $32,000 on your mortgage payment, property taxes and heating. This is how lenders qualify you when you are applying for loans.
The ratios I presented are fairly conservative. These can change slightly in some circumstances. One example is that some lenders will allow you to go to a higher TDS than 40 per cent if your credit score is above a certain number. For example, if your credit score is above 680, some lenders will allow a TDS of up to 44 per cent. Another exception that some lenders can offer is the combination of the two, often, again, if you have excellent credit. So rather than being limited to 32 per cent on the GDS, you may be able to use the full 40-44 per cent for your mortgage expenses alone.
The second component of capacity is how lenders view your income, and what they will allow you to use. This again can vary a lot between different lenders. Generally with mortgages, any income that is fairly steady (salary, set hourly schedule, etc.) can be proven with a job letter and recent pay stub. The amount stated by the employer on the job letter is the income figure used by the lender as long as that person is not on probation.
Where things can get a little more difficult is when wages can vary. This often happens for self-employed workers, seasonal workers and hourly workers where there are no guaranteed hours given. Usually in these circumstances, a lender will require proof of past income via notice of assessments. These are the papers that you receive back from the Canada Revenue Agency when you file your taxes. It is quite easy to prove income this way; the only downside is the length of employment needed. Generally a lender will want to see a two-year average. So that can be a long time to wait if you are just starting one of these jobs, whereas if you start a salaried job, you could have a mortgage approved right away as long as the employer is willing to state that you are not on probation.
This is just a broad level look at how lenders look at “capacity”. Like I mentioned, each lender will have their own guidelines and ways of looking at things. There are a number of mortgage calculators available online to help make this process simpler. I have one on my website at www.deanbala.com.
Dean Bala is a mortgage broker and Realtor working out of the Creston Valley Realty office in Creston.