What is a Debt Service Ratio?
The mortgage loan approval process can often seem like a complete mystery with mortgage applicants rarely understanding why they were approved or rejected. Before you jump head first into looking for a home and applying for a mortgage, it’s important to know what is financially expected of you.
Learn how to successfully shop for a mortgage, here.
Debt service ratios are two ways that mortgage lenders determine your creditworthiness. The Total Debt Service (TDS) Ratio and The Gross Debt Service (GDS) Ratio are always used by mortgage lenders to figure out if you can actually afford to take on a mortgage loan. Having a healthy GDS ratio and a TDS ratio should be a priority for anyone looking to purchase a house.
Gross Debt Service Ratio
The GDS ratio gauges the amount of your after tax earnings that you’ll need to use to pay for any monthly costs associated with owning a house. These costs are as follows:
- Property tax
- Mortgage payment(s)
- Condo fees (only if you’re looking to purchase a condo)
- Heating bill
The industry standard is 32%; this means that your GDS ratio should be 32% or less. When your GDS ratio is 32% or lower it provides your lender with the confidence that you can afford to buy a house.
How a GDS Ratio is Calculated?
All mortgages lenders use this formula to determine your GDS ratio. The formula is straight forward and easy to understand which means you can calculate your own GDS ratio if you want a better understanding of your financial situation.
GDS = (P.I.T.H. + ½ Condo Fees)/ Monthly After Tax Earnings x 100
P.I.T.H stands for mortgage principal, mortgage interest, property taxes and heating. You add up all these expenses, plus condo fees if you’re buying a condo. Divide by your monthly take home income and multiply that number by 100. This will give you your Gross Debt Service Ratio.
Let’s say each month your mortgage payment is $1,600, your property taxes are $200, your heating bill is $75 and you take home $7,000.
GDS= ($1,600 + $200 + $75) / $7,000 x 100 = 26.78%
Your GDS ratio would be 26% which is significantly lower than the 32% industry standard; you would then have no trouble getting approved for a mortgage.
Total Debt Service Ratio
The TDS ratio takes into consideration even more of your financial responsibilities to determine whether you can afford a mortgage loan. Your TDS ratio still takes into consideration of all the same expenses as the GDS ratio (mortgage payments, heating bills, property taxes), but also looks at how much of your monthly income is going towards debt repayment. Monthly debt repayment consists of:
- Car loans
- Credit card payments
- Lines of credit
- Student loans
The industry standard for a TDS ratio is 40%; this means that your TDS ratio should be 40% or less.
How a TDS Ratio is Calculated?
Once more, all lenders use this formula to determine TDS ratios. Should you wish to calculate your own TDS ratio, here is the formula you can use.
TDS = (P.I.T.H. + ½ Condo Fees + Monthly Debt Payments)/Monthly After Tax Earnings x 100
Let’s say each month your mortgage payment is $1,600, your property taxes are $200, your heating bill is $75, you have a car loan that costs you $400, credit card debt that you pay $200 towards each month and you take home $7,000.
TDS = ($1,600 + $200 + $75 + $600) / $7,000 x 100 = 35.35%
Yours TDS would be 35%, which is lower than the industry standard. This would make you a desirable candidate for a mortgage loan and you shouldn’t experience too much difficulty getting approved, especially if your credit score is high.
Is there ever a right time to purchase a house? Read this article for more information.
The Bottom Line
These two debt servicing ratios are useful tools that potential mortgage lenders will use to determine your creditworthiness, but it’s important to understand that they are not the only things taken into consideration when approving mortgages. Your credit history and credit score are also very important factors that will be used during the mortgage approval process. Overall financial health will afford you the best opportunity to get approved for the mortgage loan you want.