Mortgage rules tightening

Canada Mortgage and Housing Corporation (CMHC) has announced three significant changes to the way insured mortgage applications will be evaluated effective July 1, 2020. 

These changes are:

• Debt service ratios are changing to 35/42 from 39/44
• At least one applicant must have a minimum credit score of 680
• Borrowed funds can no longer be used for a down payment

Before I get into potential impacts for borrowers, I want to explain what debt service ratios are and how we use them when calculating how much you are able to borrow to buy a home. 

There are two ratios we use: 

• Gross Debt Service
• Total Debt Service

Gross Debt Service:

At the current time, the first rule is that your monthly housing costs shouldn't be more than 39 per cent of your gross monthly income. Housing costs include your monthly mortgage payments (principal and interest), property taxes and heating expenses. This is known as PITH for short —Principal, Interest, Taxes, and Heating. 

If your credit score is less than 680, this ratio is reduced to 35 per cent of your income.

Lenders add up your housing costs and figure out what percentage they are of your gross monthly income. This figure is called your Gross Debt Service (GDS) ratio. To be considered for a mortgage, your GDS must be 39 per cent or less of your gross household monthly income. 

Total Debt Service:

The second rule is that your entire monthly debt load should not be more than 44 per cent of your gross monthly income. Your entire monthly debt load includes your housing costs (PITH) plus all your other debt payments (car loans or leases, credit card payments, lines of credit payments, etc.). This figure is called your Total Debt Service (TDS) ratio.

If your credit score is less than 680 this ratio is reduced to 42 per cent.

For a more thorough explanation of how we calculate what you are qualified to borrow, check out a previous post Mortgage pre-approval – Know what you can afford.

Let’s look at how the changes coming into effect July 1 will affect your mortgage application.

Borrowed down payment:

Currently there is a Flex-Down program available that allows people to use borrowed funds as part of their down payment. To do this, the payment for any borrowed funds has to be factored into debt service calculations. 

This is not a program I have ever used with my clients. I have discussed it with a few over the years, but in these cases adding in the payment for the borrowed funds pushed their debt service numbers out of line so they opted not to use the program.

Minimum Credit Score of 680: 

The second change may impact a few more borrowers. At the current time, the current minimum credit score required for at least one of the borrowers on an insured application is 600. Effective July 1 that number increases to 680. 

Basing my thoughts on my client base and not statistics from lenders or CMHC,  I feel this change will affect a proportionately small group of borrowers. 

At the current time, if a borrower’s credit score is between 600 and 679, they are subject to reduced ratios of 35/42, where clients whose score is 680 or greater are able to borrow based on ratios of 39/44. 

Many lenders already have a minimum credit score requirement of 680 already so I feel the effects of this change will truly affect a limited number of home buyers.

An interesting timing twist which may mean the impact will be slightly greater is that Equifax recently made several tweaks as to how they calculate credit scores. Since these changes kicked in I have seen multiple comments from mortgage brokers across the country discussing sudden drops to clients’ scores.

Debt service ratios reducing to 35/42 from 39/44:

The reduced debt service ratios will most significantly affect borrowers. 

I want to dollarize this for you and give you a concrete example of how this will affect your borrowing power.

Using a household income of $75,000 and assuming:

• a minimum down payment of five per cent
• no consumer debt
• a credit score of higher than 680
• a strata fee of $300 per month and gross property taxes of $2,000 annually

Based on current guidelines, you would be qualified to purchase a home priced at $350,000.

Based on the reduced debt service ratios after July 1, your maximum price drops to $310,000.

If you have been pre-qualified to buy a home and are currently house hunting, I cannot stress how critical it is that you touch base with your mortgage person to see how these changes may affect your application.

My understanding is that if you have an accepted offer and your application has been submitted to CMHC prior to July 1, your application will be evaluated using the old rules.

If you write an offer and it is not submitted prior to July 1, your application will be reviewed under the new guidelines. If you have written at the top of your price range based on a prequalification done based on a 39 per cent GDS, your application may not be approved.

A couple of important things to note. There are three organizations in Canada that provide mortgage default insurance: CMHC, Genworth, and Canada Guarantee.

Genworth and Canada Guarantee have not yet announced changes to their underwriting policies but historically follow CMHC’s lead. 

We have not yet heard from lenders as to whether they will be evaluating mortgage applications where clients put down 20 per cent or more.

I am struggling a bit as to how to wrap up today’s column. There is a huge discussion to be had around why these changes are being made, if they are necessary, what the true desired outcome is, and how this may impede access to home ownership.

When CMHC introduced the Stress Test in October 2016, we were all very concerned about the impact the Stress Test would have on borrowers. A very general observation is that this reduced borrowing power by 20 per cent.

We adjusted and this change became business as usual. Looking back and comparing applications pre- and post-stress test, again based on anecdotal experience and not hard stats, I will say that I am seeing more applications that require either additional down payment or strong co-borrowers. What I haven’t noted is a dramatic decrease in house prices.

Evan Siddall’s (CEO of CMHC) presented to the Standing Committee on Finance May 19. One of the statements from his speaking notes really made me pause.

“Homeownership is like blood pressure: you can have too much of it. Housing demand is far easier to stimulate than supply and the result, as we’ve seen, is Economics 101: ever-increasing prices. So if housing affordability is our aim, as surely it must be, then there must be a limit to the demand we help to create, especially when supply isn’t keeping up.”

If you are interested in reading the whole document, it can be found here.

So what is the true intent behind the changes? To keep more people in the rental market as opposed to becoming home owners? To help protect Canadians from becoming over-extended financially? To take a more conservative approach as we navigate through what our economy will look like post-COVID-19? To drive home prices down?

A prudent approach to qualifying home buyers is absolutely necessary. Some markets will feel this more keenly than others, and this arguably boils down to lifestyle choices. 

My concern is that these changes will impact lower wage earners the most dramatically. These are the clients who are already struggling to get into the housing market.

In our area, I find that clients in the lower income brackets are paying more in rent than the housing expenses would be for a similar unit.

I have said before and will say again that a more prudent approach to consumer debt like credit cards and car loans will go a long way to preventing Canadians from becoming over-extended financially. For the majority of the refinances I work on, clients find themselves stretched too thin because they have charged too much on their cards or purchased vehicles with expensive payments.

It is pretty easy to walk into a car dealership and come out with a brand new car. Certainly far easier than it is to buy a home.

The bottom line is that we will adjust to these changes. They too will become business as usual. 

If you are currently shopping for a home, I cannot stress how important it is to touch base with your mortgage person to see how the changing guidelines may affect your mortgage application.

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.