For first time homebuyers, knowing the maximum amount you can borrow for a mortgage is crucial. Armed with that, homebuyers have a realistic view of houses that are within their reach to buy.

Life is more than a mortgage

Shelter is only one important part of life's necessities. Simply put, mortgages provide us with leverage to buy a home without paying for it in full. But mortgage payments should not amount to more than 40 per cent of your income, the remaining 60 for all other investments/expenses.

Gross Debt Service and Total Debt Service Ratios

Over the years, banks have come up with a pair of ratios to gauge if one can afford a mortgage. Gross debt service ratio (GDS) is the percentage of new mortgage payment and home expenses over gross annual income.

GDS = (Mortgage Payment + Property Taxes + Heating Costs) / Income before Taxes

Banks will generally approve a loan that carries a GDS less than 32 per cent.

While GDS focuses on the requested amount for a mortgage, total debt service ratio (TDS) goes further to include all other debt payments. It is the percentage of all debt payments (including the new mortgage payment) over gross annual income.

TDS = (Mortgage Payment + Property Taxes + Heating Costs + Other Debt Payments) / Income before Taxes

Mortgage lenders will not approve any applications with a TDS of more than 40 per cent.

Maximum mortgage amount

Let's look at an example. John earns $34,000 a year and his wife Jill brings home another $25,000 annually before taxes. The property tax and heating costs are estimated as $2,000 and $900 respectively. For a mortgage with a 40-year amortization at six percent, how much can they borrow?

(1) GDS=32%,

32% = (Monthly Payment x 12 + 2000+900)/59000
Therefore, the monthly mortgage payment (including principle and interest) is $1,331.67. This amount is equivalent to a mortgage of $242,000.

(2) TDS=40%

If they have a car loan with a monthly payment of $500 and a credit card payment of $300 each month, the situation will change.

40%=(Monthly Payment x 12 + 2000+900+12x(500+300))/59000

Therefore, the monthly mortgage payment is left at $925. This the monthly cost for a mortgage of $169,700.

To combine these calculations, the maximum mortgage John and Jill can get is $169,700 (the lesser of the above two mortgage amounts). Their maximum purchase price is then the above sum plus any down payment.

The chart below provides you with an estimate of how much you can borrow based on your gross annual income.

Other methods to calculate

There are two simple ways to calculate the mortgage you can afford: (1) Use multiples of four. If you do not have other debts or your total monthly debt payment is less than $400, your maximum mortgage amount is four times of your annual income before tax. (2) You can also use online calculators on most banks and mortgage brokers websites.

Quite simply, the more your income, the more you can borrow. The more debt you have, the less you can borrow. Although most mortgage lenders use these standard ratios (32/40) as their main criteria, some may go beyond these standard ratios if you have a good credit history and the loan to value ratio is below 80 per cent. In this case, you can actually borrow more than the calculated maximum amount.

Martin Shao is the president of Valueland Mortgages. Forward your mortgage questions to mshao@valueland.ca or visit his website valueland.ca.

Originally published in Real Estate News by Star Media Group on Nov. 30, 2007.