Keystone Appraisals

Keystone Blog

April 28th, 2011 4:34 PM

As appraisers, we provide market evaluations for a multitude of reasons; from financing for the purchase of a first home, refinancing of an existing home, foreclosure, divorce, etc. Involved in these decisions are a myriad of emotions that range from utmost in happiness to deep sadness. Often, particularly in these uncertain economic times, an analysis of both the Gross Debt Service Ratio and Total Debt-to-Service Ratio could alter the negative impact of mortgage financing decisions.

Since my last blog, some financial institutions have increased the fixed mortgage rates. They have left the variable as it is tied to the Bank of Canada overnight rate. As we have benefited from record low interest rates over the last few years and it now appears that interest rates will start to creep up, many will be considering to lock in at a fixed rate or to continue with a variable. There are reasons for either and it will depend on your budget, your nerve and risk tolerance.

fixed rate does provide a sense of security in that you know what you mortgage payments will be over a determined period of time. This would be important if you, like many, do not want to keep tabs of what is happening to interest rates and pick that ideal time to lock in, or if you are on a tight budget and cannot risk an increase, or you are a worrier and will lose sleep fretting on what is happening to rates.

Some, particularly those with a more flexible budget, will make the decision to go with a variable rate but will be keeping an eye on inflation, the Bank of Canada rates and other economic indicators. The reason is that the variable rate are based on prime, less a percentage (percentage varies with financial institution). There are studies that show that with a variable rate option less interest is paid over the life of a mortgage. I found on the CanEquity website a 10 year history that compared Fixed Rates vs. Variable Rates Mortgages. It should be noted that during this period of time the general trend of interest rates was decreasing.

In my last blog I indicated will look at the interest and principal repayment over mortgage durations and the impact of increasing interest rates. A look this morning indicated that prime rates are at 3%, qualifying rates are at 5.69% and the next Bank of Canada meeting is May 31, 2011.

Below is a table for four different scenarios. It is based on a mortgage loan of $250,000 amortized over 25 years with a 5 year interest term. Payments are monthly. The variable interest rate of 2.75% is based on a constant rate which of course as variable interest rates can fluctuate and is used for demonstration purposes only. The interest rate of 3.69% was a 5 year fixed posted rate in January, 2011. The 5.69% rate is the posted rate today for a 5 year fixed. I also added a 7% interest rate to further illustrate the impact of interest rates on your pocketbook.

Interest Rate

Monthly Payment

Interest Paid over 5 years

Mortgage Amt. Still Owing at end of 5 yrs.

2.75%

$1,151

$31,727

$212,650

3.69%

$1,273

$42,847

$216,444

5.69%

$1,554

$66,819

$223,595

7.00%

$1,751

$82,674

$227,611

Source: http://www.cibc.com/ca/mortgages/calculator/mortgage-payment.html

The table clearly identifies what impact interest rates have on your:

Monthly payments;
Interest paid over a 5 year period, and;
The amount still owed at the end of 5 years.

I started the blog by asking what is your Gross Debt-to-Service Ratio and Total Debt Service atio as it could aid in many of your next financial decisions, whether not only deciding on buying that house, car or even racking up that line of credit, but what is the amount of dollars you are comfortably willing to spend on those purchases. Both are measures that financial lenders will use in a preliminary assessment in lending money. It should be stressed that there are numerous other factors that are considered in the lending process. However, I mention these two ratios as I believe that everyone should be aware of them and know how to use for their own personal assessment of financial vulnerability now and as you move into the future.

Gross Debt Service Ratio is calculated as:

Annual Mortgage Payments + Property Taxes
Your Gross Family Income

The rule of thumb is that anything over 30% is unacceptable.

So, let’s take a look at how interest rates impact this by looking at an interest rate of 3.69% and 5.69%. Property taxes are $2,400 per annum and gross family income is $65,000.

Interest Rate 3.69%:

$1,273 x 12 months + $2,600

=

27.5%

$65,000

Interest Rate 5.69%:

$1,554 x 12 months + $2,600

=

32.69%

$65,000

With this scenario, at an interest rate of 3.69%, the amount of debt to be carrying is considered acceptable. However, with an interest rate of 5.69%, the gross debt service ratio indicates an unacceptable amount debt.

Total Gross Debt Service Ratio is calculated as:

Annual Mortgage Payments + Property Taxes + Other Debt Payment & Obligations
Your Gross Family Income

The two ratios are similar except that the Total Gross Debt Service Ratio takes into account other debt (car loan or lease payments, credit card payments, etc.) and obligations such as housing costs (insurance, utilities, etc). The Bank of Canada indicates that a “high” total debt service payment is 40% or more and that households with a “high” debt service ratio are financially vulnerable and more likely to have problems meeting debt obligations.

If, for example other debt and obligations totals $650 per month or $7,800 per annum, the total gross debt service ratio, with our above interest rate scenarios, would equate to:

Interest Rate 3.69%:

$1,273 x 12 months + $2,600 + $7,800

=

39.5%

$65,000

Interest Rate 5.69%:

$1,554 x 12 months + $2,600 + $7,800

=

44.7%

$65,000

It does not take much to change a financial situation, positively or negatively. By evaluating you financial position and realistically looking at expenses and debt and determining your comfort level on affordability, owning a home can be wonderful and richly rewarding experience. My opinion is that particularly in these times of fluctuating cycles and uncertainty, not to max out your affordability but to leave room for uncertainties and thus live within your means.

The CMHC website has good spread sheets for determining budgets, expenses, etc.

DISCLAIMER: Please note that the information and materials located on our web site is provided free, for general information only, and is not intended to provide or be relied upon as specific professional advice. This information represents the current technical facts as understood at the time published, but is in no way comprehensive and you should not act or rely on it regarding your specific situation. No liability is accepted therefore for any errors or losses that may be incurred if it is relied on "as is". The use of information posted on these pages does not create a consultant-client relationship.

Posted by Gina Ironmonger on April 28th, 2011 4:34 PMPost a Comment (0)

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