When my wife and I bought our home, we made the decision to not to go over $450K. We were approved for much more (like $1 million plus), but it was just way outside of our comfort zone. Even though we had a huge down payment, we just didn’t feel comfortable borrowing a ton of money just to own a home. More importantly, we didn’t want to be house poor. We enjoy our lives too much as it is.
We chose not to spend more than three times of our income on our home, but the reality is unless you’re willing to make sacrifices, the home you buy will most likely cost much more than that. So if you can’t simply use a multiplier how do you come with a number?
Understand your gross debt service ratio
Just about every lender these days uses a Gross Debt Service Ratio (GDS) to figure out how much you can reasonably afford. The number is determined by adding up all your expenses (current loans + anticipated mortgage, utilities, property taxes) and then dividing them by your household income.
A ratio of 32% determines how much debt you can afford to carry. So generally speaking, if no more than ⅓ of your income is spent servicing debt (your mortgage and any other loans), then you should be able to afford it comfortably. Personally, I think this ratio should apply to after-tax income, yet I’ve seen some lenders base it on gross income. That makes no sense to me since the only money we have to spend is what we have left after paying taxes.
To put these numbers in perspective. TheRedPin looked at average real estate prices in the GTA and found out how much income a couple needs to afford them based on a GDS of 32%. The results are a bit ummm eye-opening.
Are those realistic numbers?
Well, it depends on who you ask. The above figures are based on the GDS ratio of 32% so if you have the income, there’s a good chance lenders will loan you the money. In fact, you’ll technically be able to afford even more when you factor in your down payment.
Now do I personally think the GDS is a realistic ratio to determine home affordability? Not at all. What the GDS doesn’t consider is the cost of life. I’m not talking about groceries and entertainment. I’m more concerned about long-term things such as taking a vacation, saving for retirement, and the ability to afford kids in the future.
The GDS determined that I could reasonably afford a detached home at close to a million dollars, but when I ran my own numbers, I just couldn’t make them add up. There was just no realistic way I would be able to afford a home and continue having the same lifestyle. I’m already a pretty modest person, so I can’t imagine what some people are willing to do just to become homeowners. Heck, look at this couple who was featured in The Financial Post – they have a high income and just a 28% GDS yet they’re still struggling with their bills.
So how do you determine what you can really afford? Rob Carrick’s Total Debt Service + Savings Ratio calculator is probably the best way to figure it out. Don’t forget, you also need to consider interest rates, they’ll go up eventually, so make sure you’ve built a buffer for yourself.
Disclosure: I used the services of TheRedPin when I bought my home