Q – My husband and I are thinking of starting a family and we feel we need more space. We are currently renting a downtown condo unit, but we’re wondering whether we can afford to borrow to buy a home. Is there some rule of thumb we can use to calculate the type of house we can afford so we don’t fall into the “money pit”? – Sue T., Toronto, Ontario
A – The answer to this sounds simple, but it’s not really. Buying a home is probably the biggest financial undertaking most Canadian make in their lifetimes. So it’s not something you want to treat lightly from a financial planning perspective. Most of us have to arrange for a mortgage to finance the purchase of a home. The real question then becomes, how much mortgage debt can you really afford to carry?
When you figure your monthly budget and take it to a bank loan officer or mortgage broker, they’ll apply a couple of tests to determine how much mortgage you can afford. And that in turn determines how much house you can afford to buy.
The debt service ratios
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 32% of your gross household monthly income. 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 40% of your gross monthly income. Your TDS is the ratio of your total of your monthly debt load to your gross household income.
Working from these ratios, you’ll be able to determine how much mortgage you can afford to carry. But the story doesn’t end there.
Costs can mount up
Based on the debt load you can comfortably carry, you’ll then have to decide on the type of home you want to go hunting for. Most younger couples just starting out will not be able to afford a single-standing home in the downtown areas of Toronto’s larger urban centres, like Vancouver, Calgary, Toronto, or Montreal. That means you’ll be looking at suburban areas, or areas even further afield – the so called “exurbs” or “bedroom communities.” Keep in mind that while prices may be marginally lower in these areas, you’ll be adding higher commuting costs to your monthly budget.
In addition, you’ll have to budget for monthly maintenance and upkeep costs of your home – costs which were buried in your monthly rental payment, but which will now come out of your own pocket – in addition to your mortgage payment.
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.
The buy-or-rent debate can quickly become complicated. Throw in the various types of mortgages and payment options available (e.g., fixed term, variable rate), and your head will soon be spinning. If so, get the help of a qualified financial advisor to help you decide what’s really affordable for you, and help you avoid the proverbial “money pit.” – Robyn