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The loan application, credit analysis, and property appraisal provide your lender with two kinds of information:
• The lender’s perceived risk of the loan: whether the contract can be structured in a way which, both initially and over the loan term, will be satisfactory to both parties?
• The “hard” data about you and the property that will be used to determine specific contract terms. This data provides the information used in conjunction with the lender’s “rules of lending” or lending policy to determine the financial details of the mortgage contract.
There are 3 ratios you should familiarize yourself with, the loan-to-value ratio, gross debt service ratio, and total debt service ratio:
Lenders need to ensure the value of your home exceeds the amount outstanding on the loan if they are required to exercise their claim against the property. The maximum loan amount you will be able to obtain, is determined by taking a percentage, referred to as the loan-to-value ratio, of the lending value.
Loan Amount = Loan-to-Value Ratio × Lending Value
*In Canada, as of March 18 ’11, the maximum amount Canadians can borrow in refinancing their mortgage is set at 85% of the value of their homes, required with CMHC’s government-backed mortgage insurance. The aim is to promote saving through home ownership and limit the repackaging of consumer debt into mortgages guaranteed by taxpayers.
A debt service ratio essentially determines the maximum loan which can be supported by your current income. Once the maximum loan, as justified by the lending value of your chosen property and the maximum loan, as justified by your income have been determined, the lender will choose the lower amount.
In order for your lender to protect against default, there are certain restrictions that limit the apportioned amount of income that will be attributed towards monthly debt payments.
The ratio is defined as the ratio of the sum of the annual first mortgage payments (principal and interest) and real property taxes to annual gross income:
Gross Debt Service = (Principal + Interest + Taxes) ÷ Gross Income
*Generally, the amount should be no more than 32% of your gross monthly income, to pay for mortgage payments and real property taxes (and, possibly heating costs, maintenance fees, or registered junior mortgage programs).
A total debt service ratio indicates your overall indebtedness, and includes extraneous debts that were excluded form the gross debt service ratio.
The ratio is defined as the ratio of annual payments on all debts (first mortgage, property taxes, maintenance fees, additional financing, car payments, charge accounts, etc.) to annual gross income:
Total Debt Service = Principal + Interest + Taxes + Other Payments ÷ Gross Income
*Generally, the TDS ratio should be no more than 40% of your gross monthly income.
The amortization period is the length (usually in years) of time in which the borrowed money plus interest is to be repaid in instalments. Ideally, a shorter amortization period will speed up the rate of principal repayment, as long as you can keep up with the payments. A shorter amortization period has the largest impact on first time home buyers, as these buyers are constrained by lower incomes and a lack of collateral. Even slightly higher monthly payments can make it unaffordable to acquire your desired home, as the risk of default increases.
*In Canada, as of March 18 ’11, the maximum amortization period is set at 30 years for government-backed insured mortgages with loan-to-value ratios of more than 80%.
When you are shopping for your property, it is highly recommended that you obtain a pre-qualification certificate from your mortgage lender, regardless of how certain you are that you will qualify for a mortgage. A pre-approved mortgage calculates the maximum loan for which you qualify, based on your current financial situation and a satisfactory credit review.
Here’s why you should get pre-approved:
• Getting pre-approved for a mortgage guarantees that you will have a locked in interest rate for a period of 60-120 days while you search for a property, even if the interest rate for the term happens to increase. Conversely, if the mortgage rate decreases, you will be able to capitalize on the lower rate during that period for the term selected.
• With the pre-approval in place in addition to your cash downpayment, this will provide you with the most realistic price range that you can afford. The actual terms of the mortgage amount will be finalized based on the value of the home purchased, which is often subject to a satisfactory property appraisal.
• You increase your credibility when making an offer on a property, as the seller knows you are capable of securing a mortgage and are serious about buying.