Evelyn Jacks and Walter Harder
As of June 1, eligibility for a new mortgage (or renewals with a new lender) will depend on a new stress test, and specifically, whether buyers can pay their mortgage if interest rates go up to 5.25%. This will be trying for all buyers, not just first-time buyers. However, if first-time buyers can’t meet the test, the First-Time Home Buyer Incentive may come to the rescue. Tax and financial advisors need to know the details to advise on the pros and cons and do the “homebuyer’s math” to make sound recommendations.
Under the new mortgage “stress test,” home buyers will have to show that they can pay the higher of the interest rate offered plus 2% more, or 5.25%. For CMHC-insured mortgages, this is an increase from 4.79% prior to June 1.
For uninsured mortgages taken by homeowners who have at least a 20% down payment, there was no stress test prior to June 1. Note however, that now even those with the minimum 20% down must meet the interest rate stress test.
Here’s an example that advisors may wish to discuss with clients who are considering a new mortgage:
Nilam wants to buy a new home for $500,000 with a $100,000 down payment. To qualify for the $400,000 mortgage, Nilam will have to be able to afford to make payments as if the rate were 5.25%. Assuming the most common 25-year amortization, the monthly payments at 5.25% would be $2,383.67.
Now, if Nilam were offered a 2.5% fixed-rate mortgage, her payments would actually be $1,791.86 per month, but she’ll have to show she has enough income to be able to afford the $2,386.67 monthly payment.
To qualify, she must meet two criteria:
1. Her gross debt service ratio must be no more than 32%. The gross debt service ratio is the ratio of the total cost of mortgage payments, heat, and property taxes to her before-tax income. Assuming heat and property taxes are $400 per month, Nilam’s gross income would have to exceed ($400 + $2,383.67)/32% = $8,698.97 per month or $104,387 per year.
2. Her total debt service ratio must be no more than 40%. The total debt service ratio is the ratio of all debt payments, including the mortgage to her before-tax income. Assuming Nilam has a $600 monthly car loan payment and also pays $1,000 on other loans and credit cards, her gross income would have to exceed ($1,600 + $2,383.67)/40% = $9,959.18 per month or $119,510 per year. Depending on her province of residence and any other credits she might be eligible for, the $119,510 gross income required by the debt service ratio test would amount to a take-home pay of about $83,600 annually or $6,600 a month.
Using Incentives. Nilam decides to consider the First-Time Home Buyer Incentive to reduce her mortgage. Under the Incentive, she can apply to receive $50,000 in a shared equity mortgage (10% of the cost of a new home) from the federal government under this plan. She can then borrow a reduced amount ($350,000 instead of $400,000) to buy the home and increase her monthly budget.
In this case, her mortgage payments are $1,567.88 instead of $1,791.86 (monthly over a five-year period), and it is easier for her to pass the stress test, which would be based on monthly mortgage payments of $2,085.71.
Based on the gross debt service ratio outlined above, Nilam’s income would have to exceed ($400 + $2,085.71)/32% = $7,767.84 per month or $93,214 annually. Based on her total debt service ratio, her income would have to be at least ($1,600 + $2,085.71)/40% = $9,214.28 per month or $110,571 per year.
But that is not the end of the story. The government will participate in an increase in the equity of the home. For example:
Five years later, the home is sold for $650,000. Here's the government's share of the equity: $65,000 or $15,000 more than they lent to Nilam. She keeps $585,000 less the outstanding amount on her other mortgage. The equivalent interest rate the government earned for lending the $50,000 money is 5.4%. This is more than twice the amount of interest that Nilam would have paid.
The Bottom Line
Homebuyers generally have no control over the gross debt service ratio but, if their mortgage amount is limited by their total debt service ratio, they would need to reduce their debt payments in order to increase their maximum mortgage. In Nilam’s case, refinancing her credit cards to reduce her monthly debt payments could help her qualify for her desired mortgage if her income is more than $104,387 per year but less than $119,510 per year.
The First-Time Home Buyer Incentive also allows first-time homebuyers to qualify for a larger mortgage by decreasing the size of the mortgage required to purchase the new home. However, the cost of that incentive could be high if the value of the home increases significantly in value.
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