In an ideal world, you’ll be able to pay off all of your debt before buying a home. But as more and more Canadians carry credit card debt, the idea of purchasing a home after becoming debt free is turning into an outdated concept.
So can you afford to purchase a home with credit card debt? The answer is yes but it’s certainly going to make the homebuying process more difficult. Here are two ways credit card debt will negatively impact your ability to afford a home:
Credit card debt will limit the size of your mortgage
Several factors are used by lenders to determine the maximum mortgage you can afford. These factors include your income, the size of your down payment, and whether or not you have debt.
Lenders will look at two ratios: Your gross debt service (GDS) ratio and your total debt service (TDS) ratio. The GDS ratio includes your housing expenses, such as your mortgage payment, property tax, heating costs, and 50% of your condo fees (if applicable). All of these are added up and then divided by your gross annual income. Here’s the formula for the GDS ratio:
Mortgage payments + Property taxes + Heating costs + 50% of condo fees ÷ Annual income
If it’s less than the industry standard of 32%, your lender will be confident in your ability to pay your housing expenses.
But let’s look at exactly how credit card debt will affect your affordability by looking at the TDS ratio. The formula for the TDS ratio takes into account any debt you have because your lender wants to ensure you can afford your mortgage payments and the monthly payments on your debt. Here’s the formula for the TDS ratio:
Housing expenses + Credit card payments + Car payments + Loan expenses ÷ Annual Income
Let’s look at an example of determining your maximum affordability, both with and without credit card debt. In this example, you earn $90,000 annually before taxes, you have $20,000 in credit card debt, you’re making monthly payments of $600 or $7,200 a year, and you have no other loan expenses.
According to the TDS ratio, the most you can afford for annual housing expenses is $28,800.
$28,800 + $7,200 ÷ $90,000 = 40%
Now, if you didn’t have any debt at all, you could afford a higher amount of monthly housing costs while staying under the 40% TDS threshold.
$28,800 ÷ $90,000 = 32%
One thing to keep in mind is that your GDS and TDS ratios are guidelines. If you have a good credit score and either ratio is a little higher than the standard, you may still qualify for a mortgage. To determine what you can afford, use our mortgage affordability calculator.
Your credit card debt could hurt your credit score
One of the factors your lender will employ to determine your viability as a borrower is your credit score. Many factors determine your credit score but one of them is your credit utilization.
Your credit utilization is the amount of credit card debt you carry as a percentage of your overall credit limit. Ideally, you shouldn’t carry more than 35% of the total limit on your credit card. For example, if you have a credit card with a $10,000 limit, you shouldn’t carry a balance of more than $3,500. If your credit cards are frequently maxed out or near their limits, your credit score will go down.
Having a high credit score is important because it allows you to qualify for today’s best mortgage rates from top lenders.
If you purchase a $450,000 home with a 5% down payment and are able to qualify for a mortgage with a great interest rate of 2.33%, your monthly payment will be $1,947. According to our mortgage calculator, you’ll pay $141,120 in interest over the life of the mortgage.
But if your credit isn’t good, you might not qualify for a great interest rate and will have to put down a larger down payment. Let’s assume you want to buy that same $450,000 home but need to put down 15% and the interest rate on your mortgage is 4.33%. Your monthly payment will be $2,118. According to our mortgage calculator, you’ll pay $246,163 in interest over the life of the mortgage.
The bottom line
If you have a good credit score and you don’t have a lot of credit card debt, you’ll be able to afford a bigger mortgage, you’ll have lower monthly costs, you’ll enjoy lower interest rates, and you’ll save money on the overall cost of your home. Buying a home in Canada while carrying credit card debt is possible but buying a home without credit card debt is much easier.
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