The Canadian housing market took a big hit in mid-March when the COVID-19 outbreak was declared a pandemic by the World Health Organization. How did this affect the housing market and mortgage affordability?
Despite self-isolation orders, not all buyers sat on the sidelines and not every seller pushed pause on their spring listing.
Buyers looking to get into the market or move-up to a larger property are scouring the market to find the perfect place. But to make a move, homebuyers must first determine how much mortgage they can afford, as well as the maximum mortgage they can get — and the two numbers aren’t always the same.
The maximum mortgage you can afford
There are loads of guidelines and rules about the best way to calculate how much you should spend on a house, or how much mortgage can you afford. One general, but possibly outdated, rule of thumb, is to multiply your gross annual income by 2.5, to give you the maximum mortgage amount you can afford. So, if your household income was $120,000 per year, the maximum mortgage your household could afford is $300,000.
If you are shopping for a property in higher-priced markets, such as Toronto or Vancouver, this general rule of thumb may seem ridiculously out of touch with the reality of these real estate markets.
Another option is to follow Senator Elizabeth Warren’s 50-30-20 budget rule. As a former law school professor who specialized in bankruptcy law, Warren laid out her popular budget method in her book, All Your Worth: The Ultimate Lifetime Money Plan.
In the simplest terms, Warren suggests diving up your after-tax income and allocate 50% to your needs, 30% on your wants and 20% to savings.
Going back to that family that earns $120,000 gross, let’s assume their after-tax earnings are close to $85,000 per year. That would allow them to spend $42,500 on needs, which works out to just over $3,540 on the mortgage, property tax, utilities, food, transportation (you need to get to school or work!), as well as insurance.
Let’s assume that out of the $3,540, your family spends $1,000 on all expenses, excluding the mortgage. This means you could buy a home with a mortgage payment that does not exceed $2,540 per month.
How to calculate how much mortgage can you afford?
Now that you have an idea of how to calculate where your money should go, you can work backwards to find out the maximum purchase price of a home.
Using the example above, and a mortgage calculator, you can work backwards. For example:
Based on these calculations, the maximum mortgage you can afford would be between $429,000 and $530,000. Assuming a 20% down payment, the maximum house purchase price you can afford is between $537,000 and $660,000.
The maximum mortgage loan you can get
Now that you’ve calculated the maximum monthly mortgage payment you can afford, it’s time to see what a mortgage provider will lend you.
In general, the amount of mortgage you can qualify for depends on four factors:
- Your income
- Your debt
- Your credit score
- Your lender’s mortgage rate
How much you earn
How much you make each year is an important factor for a lender in determining how much mortgage you can afford, as it helps determine how much money will be available to pay down the mortgage debt.
Most lenders will want to know your gross income, as well as any additional income you expect to earn on a regular basis.
Lenders will also want to know how secure and stable your employment is with your current employer.
All things being equal, borrowers with safe, secure, long-time, full-time employment with large, well-known employers will get access to the best mortgage rates — and the better your mortgage rate, the greater the access to a larger mortgage.
How much you owe
What you earn is one part of the equation lenders consider when qualifying you for a mortgage. The other side is debt.
Lenders will want to know your current debt obligations, including how much you owe on current mortgages, personal loans, car financing, student loans, as well as store and credit cards.
The more debt you hold, in relation to your income, the harder it will be to qualify for a mortgage or to get a good mortgage rate.
Your credit score
Lenders will also review your credit score and your credit report to determine mortgage affodability.
Your credit score is a high-level snapshot of how responsible you are as a consumer. Do you pay your bills on time? Do you make minimum payments? Do you typically carry large balances? The more frequently you pay your bills and pay off your debts, the higher your score.
>>For more read: How credit scores impact house buying
Impact of Mortgage Rates
Finally, the total amount of mortgage you can qualify depends a great deal on the mortgage rate you are able to secure.
As mentioned above, the higher the mortgage rate, the less you are able to borrow. For example, if one lender offered you a mortgage at 3%, while another lender offered you a mortgage at 4%, you would lose 10% of your purchasing power by selecting the mortgage contract with the higher rate. Jump up from 3% to 5% and you’d lose 19% of your purchasing power.
This loss of purchasing power is now a reality for all buyers because of the 2018 mortgage stress test. Based on these regulations, borrowers must qualify based on the rate the lender offers plus 2% or qualify based on the Bank of Canada’s current five-year benchmark rate, whichever is higher. (As of April 2020, the BoC’s five-year benchmark rate was 5.04%.)
While a lender may tell you that you can afford a big mortgage, that doesn’t necessarily mean you should max out your home purchase price. Remember, the lender’s criteria focus largely on gross earnings and don’t factor in costs you consider important, such as daycare fees, pet expenses or dental bills, to name a few.
To get a true picture of how much mortgage can you afford, spend a bit of time calculating your expenses and comparing that with your earnings. Apply Warren’s 50-30-20 rule and you’ll have a budget that should allow you to absorb financial setbacks while saving for the future and paying for the present.