Let’s look at “The ABC’s of Mortgage Qualification.”
- Credit & Debt
- Down Payment & closing costs
- Employment & Income
- Full process
There’s a lot here, bookmark this page and come back to it as you need.
- Awareness – How does a mortgage work?
- Budget – What can you realistically afford to pay each month?
- Credit & Debt – What does my credit score need to be?
- Down payment & closing costs – How much cash do I need up front?
- Interlude: Calculating purchase prices from your affordable mortgage payment
- Employment & Income: What income can I use to qualify for a mortgage?
- Full process: What does the home buying process look like?
- Recap: What do I actually need to do now?
Awareness – How does a mortgage work?
What are you even applying for? You’re going to sign a lot of paperwork when you get a mortgage. What are you agreeing to?
Here’s an overview of how most mortgages work. These are all general introductions to much deeper topics and definitions. Use these definitions as a starting point for your investigation.
- Down payment
- This is your “skin in the game.” As long as your down payment comes from savings, investments, or a gift, this is your equity. It’s how much of your home you actually own. In Canada, anyone can pay as little as 5% down on a home they are planning to live in. You’ll need a mortgage for the rest of the purchase price of your new home.
- Mortgage default insurance
- If you’re putting less than 20% down on your home, you’ll need to pay a “mortgage default insurance” premium. Home values could easily correct (drop) 20% in a year (we saw that in 2018, and again in 2022). That doesn’t leave the lender with a lot of wiggle room. So they buy default insurance and pass that insurance premium onto you. Usually the premium is wrapped into your mortgage and you pay interest on it. Although you can pay the premium up front if you’d like.
- Principal and interest
- Every mortgage payment has two components, principal and interest. Your mortgage principal is your outstanding mortgage balance. Your interest amount is not a simple calculation. It’s the total of your interest rate times your mortgage principal, compounded every 6 months (or every month for variable rate mortgages) over 25-30 years (your amortization). The principal and interest portion of your payments are not equal. In the beginning, you’re paying more interest than principal. Gradually, the interest portion decreases and the principal portion increases until you’ve paid off the entire principal amount.
- This is the length of time (usually 25-30 years) that interest is calculated on your mortgage. If you have a 25 year mortgage, the lender assumes you’ll stick with them for those 25 years, calculates how much interest you’d pay over that period of time, then splits up the interest (unevenly) into each payment through that period.
- All mortgages in Canada must have a “term,” or maturity date, when you’re allowed to renegotiate your mortgage contract. The most common term is 5 years. But you can go as low as 1 year. On your maturity date, there is no penalty for breaking your mortgage contract when selling your house, switching lenders, or refinancing your home.
- Pre-payment penalties
- If you sell your home, switch lenders, or refinance (re-mortgage) before your term is up, you’ll be charged a “pre-payment penalty.” For fixed rate mortgages, the penalty is usually the greater of 3 months interest or the interest rate differential (IRD). An IRD is the difference between your current interest rate and the interest rate that your lender is offering on new mortgages with a similar term. Pre-payment penalties for variable rate mortgages are usually just 3 months interest.
- Pre-payment privileges
- Most mortgages let you directly pay off a portion of your principal amount each year. That portion can be anywhere from 10% – 20% of your original mortgage balance. Paying off more than your allowed amount triggers fees and penalties.
- Payment frequency
- You can pay monthly, bi-weekly, or weekly. You can also choose “accelerated” bi-weekly or weekly payments which increase your payments slightly, paying off your mortgage sooner.
- Fixed vs. Variable interest rate
- A fixed interest rate stays the same during the term of your mortgage. You will always have the same mortgage payment, regardless of whether interest rates go up or down in the market. A variable interest rate changes as the market rate changes. You can have a static payment and variable rate, so your payment doesn’t change, but the amount of interest on each payment fluctuates, extending or shortening the life of your mortgage. Or you can have an adjustable rate where the payment fluctuates as the interest rate changes. This way your mortgage principal continues to pay down on schedule.
Budget – What can you realistically afford to pay each month?
What’s your household, “take-home” income? It could be income from jobs, a business, contract work, commissions, child care benefit, child support, spousal support, pension, dividends, investments, etc. Total that up for everyone who will be on the title of your home.
Now tally up all of your expenses. How much do you need for gas, groceries, monthly subscriptions, vehicle payments, car insurance, life and disability insurance, student loans, credit card and line of credit payments, monthly savings and investments, etc.
Will the cost of utilities at your new home be comparable to what you’re paying now? Add that to your expenses.
Now subtract your expenses from your income. How much is left over? We’ll call this your “net income.”
That’s how much you can afford for:
- Mortgage payment
- Property taxes
- Fire insurance
- Condo fees
- NOTE: Sometimes condo fees include property taxes.
How do you estimate property taxes, fire insurance, condo fees?
For property taxes and condo fees, go to realtor.ca, find houses for sale in the area you’d like to live, and read through the listings to see if any have taxes and condo fees listed. Use an average value for the type of home you’d like to buy.
If you can’t find any value listed, reach out to friends and family who live in the area. Or a good realtor will give you a realistic average for the type of home you want to buy.
For fire insurance (AKA home insurance), call a local insurance agent and tell them what you’re hoping to buy. Be clear that you haven’t qualified for the mortgage yet and you’re running numbers to see what you should budget for insurance. Or you could plunk $100 / month in there, understanding that your actual amount could be very different.
Now you have an estimate for property taxes, condo fees and fire insurance. Subtract those from values from your net income.
What’s left is how much you can afford for a monthly mortgage payment.
We’ll call that your “affordable mortgage payment.” Hold onto that number for now.
Can you afford maintenance costs?
I rented an old house in Hamilton back in 2018. It was a solid house, kept in good condition. The landlord was responsive and reasonable. A few months after moving in, the tub leaked through the second story floor into our kitchen. He was there to repair it that day (he is a plumber by trade).
Then the fridge seized up on me. Twice. Once he had to replace the fridge and the second time a tech had to spend a few hours on it.
If I owned that home, those appliances would have been my problem. Fixing the tub and cleaning up the leak would have been my responsibility (well, I was cleaning up anyway, but I didn’t have to fix anything).
How many times has your landlord had to call a plumber, electrician, appliance repair tech, etc. (or how much are they ignoring)?
If you owned the home you are renting, could you have paid for those repair costs?
In the expense calculation above, add in a $50 – $100 a month to set aside into an emergency fund. It will save you from putting any repairs or maintenance costs on credit and paying more interest in the long run.
Credit & Debt – What does my credit score need to be?
Lenders qualify you for a loan based on your credit reputation and debt to income ratio. There are exceptions to a lot of what you’re about to read here, but these standards are what we’re helping you work towards.
A credit score of 680 or higher gives you access to the best rates and terms. To keep your credit score up remember these 3 things:
- Pay your bills on time. Late payments kill credit scores.
- Keep your balances below 30% of your limit. High balances are the second highest cause of bad credit.
- Maintain 2 active credit sources (credit card, line of credit, etc) with a limit of at least $2500 for at least 2 years.
Bankruptcy and consumer proposals
Now, life happens. Bills go to collections, jobs don’t last, health issues disrupt income, something happens to your paycheque and you have to rely on credit for a while. If you’re not able to dig yourself out of the hole, you either claim bankruptcy or go on a consumer proposal.
By the way, bankruptcy isn’t better or worse than a consumer proposal. In the mortgage world, they’re treated the same (although bankruptcy is a very different process from a consumer proposal).
If you have a bankruptcy or consumer proposal in your past, lenders want to see 2 years of strong credit since being discharged. If you were just recently discharged, you can still get a mortgage, but your interest rate will be higher and you’ll have to pay an upfront lender fee.
This is where your story matters a lot. It’s the lever that helps lift you over the qualification barrier. If you have a sound reason for the collections or bankruptcy, and if you’ve established a solid reputation with credit again, we can get a lot done.
Debt to income ratio
Earlier we did a calculation of your income after real life expenses, but this is different.
Your debt to income ratio, or “Total Debt Service (TDS)” as we call it in the mortgage industry, is a calculation that lenders use to determine whether you can afford the mortgage or not. They are only concerned with what you owe others, not your day to day living expenses.
And they look at your income differently based on your employment. To keep things simple, we’ll assume you’re hourly or salary with consistent income for the last two years.
If you’re self-employed or live off commission income, even if you earn a lot of overtime, this calculation gets a lot more difficult. Really, it’s my job to calculate this. But I’ll give you a basic understanding of how it works.
Total Debt Service (TDS) = Total debt and financial obligations / gross income (before taxes and deductions)
Your TDS needs to be under 44%.
Debts and financial obligations include:
- Proposed new mortgage payment (with Stress Test interest rate)
- Property taxes on your new home (make an estimate to start)
- Heating (we use a flat $100 / month in all of our calculations)
- Loan payments (student loans, equipment, vehicle, etc.)
- 50% of condo fees (if that applies)
- Credit card and line of credit payments (use 3% of your outstanding balances for the “payment”).
- Spousal support, child support you are obligated to pay
- On the flip side, if you are receiving these support payments, they can be counted as income.
- There are others, but these are the most common.
With a 680+ credit score and TDS under 44%, mortgage qualification becomes much easier.
Note about the Stress Test
You probably noticed the first item in the list above, “Proposed new mortgage payment (with Stress Test interest rate).”
When calculating your mortgage payment for the TDS, we have to “stress test it.” That means we’re using the greater of 5.25% or the market interest rate +2%. Right now, as of April 2023, market interest rate for a 5 year fixed is 4.64% – 5.34%, depending on your down payment.
So the mortgage payment we’re using for your TDS is calculated using the market rate +2%. That won’t be your actual mortgage payment.
Down payment & closing costs – How much cash do I need up front?
The minimum down payment you can make in Canada is 5%. Anything less than 20%, though, and you have to pay for “mortgage default insurance.” Your default insurance premium is wrapped into your mortgage, so you pay interest on it over the life of your mortgage.
Your down payment is your equity, it’s the portion of your home you actually own. So putting more down gives you more ownership. But it can be hard to save up enough for a down payment. If homes in your area start at $500,000, 20% down is $100,000.
Then you need to think about closing costs.
Even 5% of $500,000 is $25,000, which is still a hefty chunk of money.
The good news is, you don’t necessarily have to save up the whole down payment. There are a few other options to help you come up with a down payment for your first home:
- Cash gift: You can get a gift, an amount of money that you’re not obligated to pay back.
- Equity Gift: It’s possible for the seller to “gift” you equity from the house. Of course, there still needs to be something in it for the seller. What can you do for them that warrants the “gift”?
- Borrowed funds: It is possible to borrow some of the money for your down payment, however, we have to add that debt to your TDS calculation. So borrowing your down payment means you qualify for a smaller mortgage amount.
- RRSP Funds: Does your company contribute to an RRSP for you? Double check. It could mean more down payment money for you. You can use up to $35,000 from your RRSP for your down payment. You just have to pay that back over 15 years. Funny enough, you don’t have to add that “payment” to your TDS.
- Government grants / incentives: Depending on where you live, or your if you have indigenous roots, there may be government grants available to help with your down payment. And then there’s the First Time Home Buyer’s Incentive that everyone has access to.
Have proof of funds ready
Now, lenders want proof for everything. So if you’re given a gift for some or all of the down payment, there’s a specific “gift letter” that your “gifter” will need to sign. And then you’ll need to download a bank statement showing the down payment funds have been transferred to your account.
If any of the down payment comes from your own savings or RRSPs, you’ll need to prove that the money has been in an account you own for at least 90 days, usually by downloading 90 days of bank statements. Also for RRSPs, you’ll need a bank statement to show that the funds were transferred from the RRSP to your bank account at least 15 days before closing.
Of course, the down payment is not the only cash you’ll need up front. There are closing costs to consider as well. Lenders will want proof that you have the cash ready for closing costs as well. They don’t want any surprises on closing day.
How much do I need for closing costs?
Common expenses that you’ll need to pay on or before closing are:
- Appraisal fee (not always)
- Legal fees, including
- Signing fee
- Title insurance
- Disbursement fees
- Land transfer tax (more on this in a moment)
- PST (8%) on your default insurance premium (if putting less than 20% down)
Ok, land transfer tax (LTT).
As a first time home buyer, you get an immediate rebate on the land transfer tax, up to $8,475 in Toronto, but only up to $4,000 anywhere else in Ontario.
As a first time home buyer in Toronto, the LTT on a $500,000 home is $12,950. With a rebate of $8,475, you only have to pay $4,475 at closing.
For a $500,000 home anywhere else in Ontario, the LTT is $6,475. With a $4,000 rebate, you only have to pay $2,475 at closing.
Interlude: Calculating purchase prices from your affordable mortgage payment
Ok, so we know you’re “affordable mortgage payment” from the Budget section above. And we know that the minimum down payment is 5%. Now we can start to play with this mortgage calculator to get an idea of what our purchase price could be.
Again, this is not how much you qualify for. I calculate your qualification amount after gathering all the proper documentation. What we’re looking for here is how much of a mortgage and purchase price you could actually afford based on your take home pay. It may be less or more than what you qualify for.
On to the calculation. Here’s a free mortgage calculator. Let’s assume these numbers:
- 4.64% interest rate for a 5 year fixed rate (as of April 2023, this will be different each week).
- If you aren’t sure what interest rates are, text me 🙂, or use 5.25% (the “benchmark rate”) and know it could be more or less.
- $2,500 affordable mortgage payment
|Down Payment Amount
|Actual Mortgage Payment
|Default Insurance Premium
|Total Mortgage Amount
|PST on Insurance Premium
|Ontario LTT After Rebate
|Toronto LTT After Rebate
|Down Payment Amount
|Actual Mortgage Payment
|Default Insurance Premium
|Total Mortgage Amount
|PST on Insurance Premium
|Ontario LTT After Rebate
|Toronto LTT After Rebate
Employment & Income: What income can I use to qualify for a mortgage?
The most important question here is, “What’s your guaranteed income?” How much is reliably being deposited into your account each month and can you verify that?
If you are paid hourly with a guaranteed number of hours each week, or if you are on salary, we can use all of your gross income (before taxes and deductions) to help you qualify.
The moment you have variable income in the mix, things change.
When we talked about the debt to income ratio (or TDS), I mentioned that self-employment, commission, and even overtime income change the calculation significantly.
If you are self-employed, work a lot of overtime, or earn commission income, the TDS calculation is very different. The debts are the same, however we cannot use gross income.
For self-employed people (and for any variable portion of your income), we use the 2 year average of your net income. So how much income are you claiming on your taxes? We’ll look at your T1 and make that calculation.
That being said, there are programs for new business owners. There are several other ways to calculate your business income, but it’s too technical for this article. This is where you want a mortgage broker involved. We’ll be able to do all of those calculations for you.
For your purposes right now, understand that claiming all of your expenses may be hurting your ability to qualify for a mortgage. Here are some things for self-employed folks to consider:
- How much can you afford to not claim?
- Talk to your accountant about how much you need to claim to keep your taxes at a manageable level.
- Pay yourself regularly from your business and make sure it’s well documented. Maybe even give yourself T4 income.
- Keep track of the personal expenses the business pays for. If it’s a significant amount each year, we might be able to use that to help you qualify.
- If your business has a large cash portion that you don’t claim, at least keep those cash paid invoices aside so we can get a sense for how much cash isn’t making it to your taxes. We might be able to use some of that to help you qualify.
The bottom line is, claim your income on taxes. That’s the easiest way to prove your income. But if it’s not that easy, there are other ways we can verify what you earn.
Other forms of income
Employment income has to be your biggest source of income. But there are other sources that can contribute to your overall income level. Here are some other income sources that we might be able to use to help you qualify for a bigger mortgage:
Canada Child Benefit
If your children are under 15 and you are collecting CCB regularly, we can usually use this income to help you qualify.
Child and Spousal Support
If you collect child and/or spousal support from an ex-spouse, this can be used as well. We’ll need to see a written agreement between you and your ex detailing what they are obligated to pay you.
This is less common for first time homebuyers, but if you receive consistent, verifiable income from investments, we can use some of this as well.
This is where the real magic happens. If you buy a house with a legal 2nd (or 3rd, or 4th) apartment, we can use the rental income to help you qualify. And, as of this writing (April 2023), we may not have to include the property taxes and heat in the TDS calculation.
That means we’re removing 2 significant expenses and adding additional income.
Buying a legal duplex is the easiest way to qualify for your first home, right now.
We have to prove the rent you’ll be receiving. That means a copy of existing leases, or brand new leases signed and dated to start within a reasonable time of closing.
If you plan to rent out a unit in a few months, we may not be able to use any rental income to help you qualify. We’ll need to see an existing history of rental income or a guarantee of rental income start reasonably soon.
A Note About Disability Income
We can’t use disability income. Unless it’s permanent disability. But if ODSP can change/reduce what you receive each month, we can’t use it.
Bring it all together
To calculate your TDS, I’m going to add together your guaranteed income, the 2 year average of your variable income, and any other sources of income we are allowed. The total is the income I divide your total debts into.
Using the TDS and your down payment, I calculate approximately how much of a mortgage we can ask a lender for.
I also consider how much your actual budget can fit for a mortgage pay, property taxes, home insurance, etc. I won’t ask a lender for more than you can afford.
With that number you can start to go shopping for a house with your favourite realtor!
Any offer you make should have a financing condition in it though. The only people who should make firm offers (no conditions) are people who have enough cash to cover the whole purchase should they not get approved for a mortgage.
Full process: What does the home buying process look like?
Here’s a general overview of each stage of your home buying process:
- Submit your mortgage application
- Send all the required documents to me
- Underwriting – I calculate numbers
- Pre-approval – We go to the lender with the best rate and terms for your situation
- Make offers – Once you have a pre-approval in hand, you start shopping for a home
Closing on your first home:
- Accepted offer in hand
- Financing condition – Give it 2-5 business days.
- Document submission – I send all of your documents to the lender for review.
- Commitment letter – If the lender approves your mortgage, we get a “commitment letter.”
- Removing financing condition – Once you have the “commitment letter,” you can remove the financing condition.
- Appraisal – Sometimes the lender will want to verify the value of the house with a full appraisal.
- “Broker complete” – All the documents are in, the appraisal value is acceptable, all the commitment conditions are fulfilled, now we wait for closing.
- Lawyer title search – Your lawyer checks the title of the house to make sure there’s no outstanding issues or liens.
- Closing – You sign all the closing papers with your lawyer and collect the keys to your first home!
Mortgage maturity, A. K. A. renewal:
- 120 days before your mortgage “maturity date” – Start thinking about what you want to do on your renewal date.
- What does it mean to “renew” your mortgage?
- If you renew your mortgage, you sign a new mortgage contract with your current lender, usually at a different interest rate. You just keep paying down your mortgage on schedule.
- Do you want to refinance, use some of the equity you’ve built up?
- If you want to add or remove someone from title, or if you want to borrow a bit of money from the equity in your home, this is the time to “refinance” and make any changes to your mortgage without penalty.
- Do you want to shop around for a better rate and switch lenders?
- If you’re not happy with the new rate your current lender is offering your, this is the time to shop around and potentially find a lender with a better rate.
Recap: What do I actually need to do now?
- Talk to a mortgage broker (ahem! 🙂) to help you map out your path to homeownership.
- Keep your credit score above 680 by paying your bills on time and keeping your credit utilization below 30%.
- Limit your debts and financial obligations.
- Save up for your down payment.
- If your income is limited, find someone to buy a home with that is in a similar financial situation as you. Also, look for legal duplexes or triplexes. And research the Residential Tenancies Act so you know your obligations as a landlord.
If you have any questions about your personal situation or the mortgage process in general, call, text or email me any time:
Happy house hunting!
All the best,
Sherwood Mortgage Group #12176