When purchasing a house, most people need a loan be able to afford the home. These loans are called mortgages. A mortgage is a legal agreement where a bank or other lender loans money and charges interest in exchange for taking the title of the borrower’s property. Upon repayment of the debt, the borrower owns the property.
In Canada, to purchase a home, the buyer must first save up a down payment for the home. The minimum amount required is five per cent of the purchase price up to $500,000; 10 per cent of the portion between $500,000 and $999,999; and 20 per cent for the amount above $1,000,000. As well, if the down payment is less than 20 per cent of the purchase price, the buyer must also purchase mortgage loan insurance.
The general rule of thumb when it comes to mortgages is that an affordable mortgage payment is two to two and half times your gross income. However, it is rarely this simple, especially in today’s hot housing market. Here is a quick guide to understanding just how large a mortgage you can realistically afford.
Keys to a Mortgage Loan Approval
After entering into a mortgage agreement with the lender, you can choose to have your mortgage payments made in one of five different time frames: monthly, bi-weekly, accelerated bi-weekly, weekly, or accelerated weekly. These payments are comprised of four components: principal, interest, taxes, and insurance (known as PITI).
As stated above, most prospective buyers can afford two to two-and-a-half times their annual gross income. This means that someone earning $95,000 per year can afford between $190,000 and $237,500. This, however, is just a broad rule. There are other specifics to take into consideration including the size of monthly payment you are comfortable with, how much the bank is willing to lend you, and how much of a down payment you have on hand to apply to the purchase.
What size of mortgage can I afford?
So now, you are probably wondering how lenders determine the amount of a mortgage loan you can afford? This isn’t quite as simple as a basic math equation. Lenders consider a variety of factors; including your gross income, credit score, debt ratio, as well as your ability to pass the mortgage stress test.
Gross income refers to the amount of money you earn each year before taxes are taken out. This includes your salary and any other earnings you receive which are included in your taxes. Lenders use your gross income to determine your front-end ratio. This is the percentage of your annual gross income that can be put aside to repay your monthly mortgage. This value should ideally not exceed 28 per cent.
The back-end or debt ratio is the amount of debt you carry in relation to your income. This is where lenders calculate the percentage of your monthly income that is needed to cover your debts. Lenders prefer if this value does not exceed 43 per cent. For example, if your gross annual income is $95,000, your maximum monthly debt payments should not exceed $3,404.
After reviewing your gross income, lenders will examine your credit score. The lower your credit score, the higher your approved interest rate will be — this is because you are deemed as being at greater risk of defaulting on your mortgage. Credit scores in Canada range from 300 to 900; with the higher value being more desirable. Typically, anything higher than a 600 is considered favourable by lenders, however with a score greater than 650, you will be offered more options and lower interest rates.
Following these key factors, potential lenders will then put you through the mortgage stress test. This is a test that determines if you can still afford the mortgage should you lose your job or face other financial stress, especially if interest rates climb. Aside from the test, it is always a smart idea to have at least two months of mortgage payments in a savings account, just in case.
Finally, the mortgage amount will be determined by the cost of the house less the down payment you apply. A down payment of at least 20 per cent is preferred by lenders; anything below this will require you to obtain private mortgage insurance. The size of the down payment affects the loan in that it decreases the amount you need to borrow. For example, if a home costs $750,000 and you can afford to put a 25-per-cent down payment on the home, you will only need to be approved for a $562,500 mortgage.
A Few More Considerations
Buying a home is no small investment and that is why it is important to speak with a financial professional before making any decisions. In addition to all the above considerations that go into a mortgage, it is also important that you consider over how long a period you want your mortgage to extend.
The greater the number of years over which your mortgage is amortized, the lower your monthly payment will be. While this may make your mortgage more affordable, it will require you to pay more interest throughout the lifetime of the loan, which adds up over time. As well, you will want to consider the size of your monthly payments — no one wants to end up house poor!