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High risk or high reward: Rising mortgage debt service ratios are must-watch data

Tracy Valko was recently interviewed by Robert McLister, writer for the Financial Post, on mortgage debt service ratios. Read below for the full article and interview.

Original Source: High risk or high reward: Rising mortgage debt service ratios are must-watch data by Robert McLister

Mortgage leverage is like an obsidian blade: a precision tool when used right but a nasty injury-maker when used wrong.

The median debt service ratio skyrocketed to an all-time high last year, according to the Bank of Canada. This makes you wonder whether people take mortgage debt loads for granted.

We can blame part of that surge on rising mortgage rates, Canada’s absurdly expensive homes, and incomes that aren’t keeping pace. But part of it is thanks to stricter mortgage regulations, lenders loosening their debt ratio limits, and borrowers seeking bigger mortgages in the “alternative” market.

Extended debt ratios can be a high-risk or high-reward proposition, depending on what kind of borrower you are. Let’s dig into that.

How debt ratios work

Two standard gauges of mortgage affordability are the gross debt service (GDS) ratio and the total debt service (TDS) ratio.

GDS is the percentage of a borrower’s gross annual income needed to cover housing costs, including mortgage payments, property taxes, heating, and condo fees, if applicable.

TDS is similar but includes all your contractual obligations, including housing costs, car loans, credit cards, credit lines, support payments, student loans, obligations on other properties, etc.

GDS and TDS standards have changed over time. Back in the day, mortgage lenders commonly capped GDS ratios at 32 per cent and TDS at 40 per cent, although lenders have offered exceptions for decades.

Nowadays, prime mortgage lenders generally allow up to 39 and 44 per cent, and that’s a hard limit for default-insured mortgages. For uninsured mortgages, you can exceed 60 per cent if you have 35 per cent equity.

More and more lenders are allowing higher debt ratios.

What’s behind looser debt ratios?

In addition to soaring home prices outpacing incomes and higher rates spurring consumer demand, our regulatory ringleaders have been a key driver.

Back in 2018, the Office of the Superintendent of Financial Institutions (OSFI) wisely started forcing federally regulated lenders to calculate debt service ratios using interest rates 200-plus-basis-points higher. That caused average debt ratios to climb on new mortgages.

As borrowers couldn’t qualify, many turned to more flexible lenders. Those lenders were happy to oblige, both to stay competitive and so they could charge higher rates for their added flexibility.

“Extended ratios are being offered from lenders across the board,” notes Vince Gaetano, principal broker at OwlMortgage.ca. They really picked up after the minimum qualifying rate rose above OSFI’s 5.25 per cent floor in March 2022, he says.

Some have suggested national limits on debt service ratios, but our banking regulator concluded otherwise last fall. “We agree that regulatory limits on (uninsured) debt service coverage should not be pursued…They would remove too much risk-based decision-making and risk ownership from lenders,” it said.

And so far, risks haven’t forced their hands. Median loan-to-income and loan-to-value ratios, which have fallen for more than two years at banks, have largely offset rising debt service ratios.

“Advances in technology and data analytics have also improved risk assessment and management,” says Tracy Valko, founder of DLC Valko Financial Ltd. “That’s allowed alternative lenders to offer higher debt ratios while maintaining acceptable risk levels.”

What should borrowers do?

More and more uninsured mortgagors are facing a decision: take on a bigger mortgage relative to their income or stay in their current rental or mortgage.

Here are five occasions when extending debt ratios might make sense:

1. You have high-income potential, a temporarily high debt load and need to buy a home now.

2. You’re self-employed and make a bunch of money, but your financials or tax returns don’t show a sufficient two-year average (prime lenders ask self-employed applicants for two-year averages).

3. You expect a windfall (e.g., inheritance, company stock options vesting, etc.) that you can use to shrink your mortgage in the next five years.

4. You expect to rent out part of your home to lower your debt service ratio.

5. You’re a retiree who wants to stay in their home, has substantial retirement savings but relatively low taxable income

Here are five reasons to run from extended debt ratios:

1. You don’t like payment stress, a factor if your income and assets aren’t as strong as you let on

2. Fat mortgage payments will strangle your cash flow, leaving you gasping when surprise bills or climbing rates hit.

3. Overleveraging gives you less ability to save for retirement outside of your home.

4. A hefty debt-to-income ratio makes it harder to qualify for other loans.

5. You want to take your chances and lever to the hilt to beat rising home prices.

This last point is one of the worst reasons to lever up. A few years down the road, slowing immigration, sky-high unaffordability, and surging homebuilding could offset falling rates, slowing annual home appreciation more than many expect.

The true risks

Despite social media myths, banks aren’t handing out extended debt ratios like candy. Borrowers who want extended debt ratios must check a lot of boxes. They need sufficient equity (20 to 35 per cent), strong and stable income and employment, a high credit score, good savings patterns, low non-mortgage debt and/or substantial assets.

Regulators and investors intensely scrutinize prime lenders like the Big Six banks, so they’re more stingy with extended debt ratios. Non-federally-regulated non-prime lenders, not so much.

“Flexible debt ratios help sustain demand in the real estate market,” but some borrowers invariably “take on more debt than they can handle,” says Valko.

In today’s high-rate climate, Gaetano thinks extended debt ratios are a risk for too many non-prime borrowers who seek alternative lenders. It’s almost “impossible” to graduate to a prime lender after a year or two, he says, given the rates and fees alternative lenders charge.

Homeowners who chose extended ratios in 2021/2022, back when alternative lenders sold mortgages at 3.49 to 3.99 per cent, have seen their renewal rates “jump to 7.99 to 8.49 per cent, crippling household disposable income,” he adds. “Many were victims of FOMO and regret their decisions.”

Yet, despite 2023’s surge in mortgage interest inflation, the sharpest year-over-year spike ever recorded by Statistics Canada, the banking system remains rock solid. Mortgage defaults will continue mounting but are still well shy of long-term averages. Nevertheless, Canada’s debt ratio trends are must-watch data, and regulators are eyeing them like a hawk on a field mouse.

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