Nearly three-quarters of Canadians have debt, according to the 2019 CFCS survey. This article explores how properly optimizing your debt levels can make a substantial difference in your purchasing power. We outline which debt payments are essential, the impact of debt payments vs debt balance and what you can do to improve the outcome of how much mortgage you qualify for.
What Debts Are Important?
Within our Guide to Buying a Home, we cover how your qualifying ratios are calculated. Qualifying ratios relate to the stress test and set a limit as to what percentage of your gross income can be made up of housing-related costs and debt payments.
When we say debt payments, we don’t mean things like the credit card you pay off each month, your cable bill, phone bill, etc. The only debts that get factored into the stress test equation are debts where you have a contractual obligation to make a recurring payment. This can include things like other existing mortgages, alimony, child support, personal loans, student loans, car leases, car financing, and more. If you’re wondering what debt will be included in your qualifying ratios, pull your credit report from any of the providers out there that offer it for free. Any debt showing up in that report will count towards your qualifying ratios.
Are All Debts Created Equal?
If you think lenders are more likely to look favourable on lower debt balances, we’ll ask you to think again. The only thing that directly impacts what you qualify for is the payment, not the balance.
Here’s an example to illustrate this point:
A $40,000 loan with a $1,000 monthly payment would hurt your purchasing power more than a $20,000 loan with a $1,200 monthly payment.
The type of debt also matters. If you have a revolving debt account (typically interest-only payments) like a credit card (where you aren’t paying it off at the end of the month) or lines of credit your credit report won’t show a scheduled payment. For the purposes of the stress test, lenders will then assume a 3% monthly repayment rate (3% x the balance) for the calculation. For this reason, having revolving debts is by far the most punitive debt to carry when it comes to qualifying ratios.
Here’s an example to illustrate this point:
A $20,000 personal loan payment could be around $188/month (assuming a 2.5% rate and 10 year amortization). However the lender will look at a $20,000 line of credit balance and calculate that you should be paying $600/month. The difference between $600/month and $188/month translates to a $68,000 loss of purchasing power. You can run the numbers for your personal debts to find out how your purchasing power is affected using our Qualifier Tool.
What Can I Do?
It’s important to remember that you can have debts outstanding without it affecting your purchasing power. As long as debt payments are no greater than 5% of your gross income, that debt load won’t affect your purchasing power at all.
But what happens if you have too much debt and your purchasing power is dipping below the amount you need?
You have a few options available:
- Consolidate debts to optimize for the lowest payment: This can include things like taking out a personal loan to pay off a line of credit or refinancing your existing property with a higher amortization to lower your mortgage payments.
- Avoid co-signing on debts unless necessary: Everything that shows up on your credit report must be factored in, regardless of your ownership stake. So even if you own 1% of a property, 100% of the mortgage gets factored into your qualifying ratios. So if your partner can get a car loan without you co-signing, stay off the application.
- Pay off debts with low balances: Loans that are reaching the end of their amortization period are usually low hanging fruit when it comes to this. If you have a $400 monthly payment on a loan you took out many years ago and the balance is only $1,600 (meaning you have 4 months left), pay out the entire loan prior to your closing date and it then doesn’t get factored into your qualifying ratios at all.
- Pay down debts: Especially if you have revolving debts like a line of credit or credit card balance, paying down the balance directly results in a lower assumed payment since lenders take 3% of the outstanding balance.
Calculate Before You Commit
Before withdrawing new loans or paying down balances, some actions can’t be undone so it’s always important to plan it out in advance. Your mortgage professional can help you create a plan by simulating your purchasing power under various debt levels and determining what would make the most sense for your situation. Properly optimizing your debt levels can make a substantial difference on your purchasing power, so it should definitely be something you consider.