For those of you who have ever purchased a home, this conversation might sound familiar to you:
Buyer: “We would like to get pre-approved for a mortgage please.”
Banker: “Great. Let me pull credit bureaus on you both and see what your credit history looks like. You’ve already provided me with the type of house you’re considering and your incomes, so just give me a minute.”
Buyer: “I hope we get approved for a good number – There’s a great house we’d like to put an offer on this weekend.”
Banker: “Ok. The report just came back. It looks like you’re pre-approved for a $300,000 mortgage with 5% down. That means you can buy a house for $300,000 as long as you have $15,000 available for a down payment, plus another $10,000 or so for closing costs.”
Buyer: “That’s great! Our parents are lending us $15,000 to help out, and there is a house that we thought was out of our range that’s listed at $330,000. If we put in a low-ball offer we might be able to get it, right at our approvable limit. That would be amazing.”
Banker: “Fantastic! I hope you get it. Let me know once you have an accepted offer and I’ll look after all the paperwork. And we’ll get you set-up with mortgage insurance then too.”
Do you see anything wrong with this back and forth? Unfortunately this conversation is typical and there are a number of problems here. While getting pre-approved is a good idea so you know what your upper approved limit is, ask questions about how this amount is determined.
How do banks decide on affordability? For the most part they lean on one mathematical ratio. And once you know it, you might think twice about making a mortgage decision based on what a bank is willing to lend you.
The Total Debt Service Ratio (TDSR) is calculated as:
Monthly amounts for your Mortgage Payment + Property Tax + Other Debt Payments + Heat Expenses
Divided by Monthly Total Gross Income (from all sources)
A bank will typically lend to a maximum TDSR of 40%. Note what is NOT considered:
– Age of the applicants
– Health of the applicants
– Number and ages and health of their children
– Lifestyle expenses of the applicants
– Total net worth of the applicants
Imagine the fictitious Crosby and Gretzky Families. The Crosby’s are 32, are childless, and have significant savings already in their RRSPs and TFSAs. The Gretzky’s are 42, have three young children (one with special needs) and have no savings at all. The bank has approved both families for the same mortgage based on their identical TDSR (because they have the same income, no debt and want the same house). Which family is best able to handle the payments? Should they both really have the same pre-approved mortgage? And what happens when interest rates increase?
This example should have you questioning the rationale of banks’ decisions. The risk of over-indebtedness will affect you far more personally than your banker, so YOU should take ownership for deciding what you can afford. If you enjoy eating out, taking expensive vacations or buying a new car every 5 years you might have a different idea of what is affordable. And if you’re in your 50s you will want an amortization period that will have you mortgage-free before you’re retired.
Stretching yourself into your next home has other implications too. You should think about the neighbourhood you’re buying into, and the impact it could have on your lifestyle. A common pitfall is to underestimate the cost of living that is determined by the ‘Jones factor’. I have had several clients admit that the neighbourhood they bought into was simply above their means – even though they could afford the mortgage – and it resulted in a creeping line of credit.
Yet another good reason to pick your next home carefully.