When buying your coffee in the morning, the only financial factor you have to worry about is whether or not you left spare change in your cup holder. When it comes to larger purchases, the financial aspect can be much more complicated. That’s why it’s important to gain an understanding of certain terms and services.
When you’re looking into buying a new home, there can be many of these and some will apply to you while others will not. If you’re planning to seek out a loan for your new home purchase, then you’re likely to hear the term “debt service ratio” often. Knowing more about this term will better prepare you to deal with a lender.
To help, we’ve outlined what debt service ratio is, and why it should matter to you.
So… What IS Debt Service Ratio?
In a nutshell, debt service ratio is a measure used by lenders to determine the maximum amount they’ll loan you for your new home purchase. In the same way you calculate your mortgage affordability, a lender will use their own calculations to decide how much they’ll lend you.
There are two debt service ratios that lenders will use for calculations: gross debt service ratio and total debt service ratio. Let’s look at these separately to learn the calculation formulas and what they mean.
Gross Debt Service Ratio
When you go to a lender for a loan, they may calculate your gross debt service (GDS) ratio. Their main goal in calculating this is to determine how much debt you might already have. Your main goal is to receive a ratio under 32%, which is typically the “acceptable level of debt”.
So how do you achieve this?
Let’s use the formula and run through an example calculation.
[Mortgage payments + Property Taxes + Heating Costs + Condo Fees] ÷ [Annual Income]
As an example, let’s say you have a monthly mortgage payment of $1,000, property taxes $200, heating $100 and no condo fees (if you’re living in a house) as expenses. If your gross annual income is $50,000, that gives you a GDS of 31.2%, meaning you would likely qualify for the loan. If you live in a condo, you’d simply have to include your monthly condo fees in your expenses.
Total Debt Service Ratio
Now that you’ve figured out your GDS, you can use it to calculate your total debt service (TDS) ratio. Lenders calculate TDS to figure out the percentage of your gross income required to cover housing costs, as well as any other debt. The acceptable ratio for TDS is a little higher at 40%, but you don’t want to be higher than that. TDS assesses other expenses such as credit card payments and car loans, so the formula looks like this:
[Housing Expenses (per GDS) + Credit Card Payments + Car Payments + Loan Expenses] ÷ [Annual Income]
As you’ll notice, you’re adding any extra debt payments to your existing housing expenses, calculated in the GDS formula.
Based on the same example above, you’d have $1,300 in housing expenses, plus your monthly debt payments. Let’s say you pay $50 a month in credit card payments, $100 in car payments, and $100 in loan expenses. Divided by your gross annual income ($50,000), your TDS ratio would be 37.2%. Since that falls under 40%, you’d still likely be qualified to borrow!
GDS and TDS are comparative measures which help lenders assess a potential borrower’s ability to pay back loans. Since they’re taking a risk in lending you money, they want to ensure that risk is low. However, calculating GDS and TDS is an important step for you to take as well, before seeking out any loans.
First and foremost, as you now know, there are benchmark ratios you need to fall beneath for a better chance of obtaining a loan. Calculating these numbers beforehand helps give you a clear idea of where you stand and helps avoid any surprises. Your GDS and TDS ratios can give you an idea of how much income you actually need for the home you want, and what monthly payments you can expect.
Also, if you do the math and your ratios happen to be above the benchmark percentages, then you have the chance to try and decrease them. By paying off some of your outstanding debts, you can bring your ratio down before meeting with a lender.
Before you start digging through storage boxes for your old math textbook, make your life easier and just punch the numbers into a handy debt service calculator. Whether you’re already looking at new homes, or just starting to consider it, it’s always a good plan to have a clear idea of your budget. Think of the many ways you can benefit from lower debt ratios, and start crunching those numbers!
GDS and TDS are just part of what lenders look at; to learn more about what affects your ability to get financing, check out our post: How Your Credit Score Impacts Your Mortgage.