Recently, a colleague came into my office somewhat frustrated that his application for a home equity line of credit had been declined.
He wanted to consolidate some debts and he could not understand why he had been declined, since he had paid down a substantial portion of his mortgage.
He did not realize that Canadian lenders are often referred to as cash flow lenders. In other words, Canadian lenders base their lending decisions primarily on what they refer to as capacity: your ability to repay a loan using future recurring income, your paycheque.
Your gross income must be able to support all basic housing costs, such as mortgage payments, property taxes, heat and hydro expenses, condo fees and all debt obligations, such as loans. This is your total debt service ratio, or TDSR, and it should not exceed 40 per cent of your gross income.
An example will demonstrate.
Assume that your home is valued at $200,000, you have a mortgage of $100,000 and the maximum amount that a lender will approve you for is 80 per cent of the value of your home, less any mortgage outstanding. Potentially, you could borrow $60,000.
Based on this calculation, the lender will assess your application to determine whether you can afford to make the additional line of credit payment, as well as cover basic housing costs and other debt payments. If your income is $65,000, the lender will assume that you can afford to pay no more than $26,000 per year, or approximately $2,167 per month.
If you have a monthly mortgage payment of $800, property taxes and heat and hydro payments of $400 a month, and a couple of car payments of $350 per month each, your total debt servicing quickly rises to just under 35 per cent of your income.
Credit cards are also factored into the lending decision. Lenders normally assume a payment of three per cent of the credit limits on credit card accounts, so if you have two credit cards, each with a limit of $10,000, the lender will add $600 (three per cent × $20,000) to your debt servicing.
Without even considering your new credit request, your total debt service ratio would be 46 per cent, well outside of the range that lenders are willing to lend.
Adding in an interest-only payment on a home equity line of credit of $60,000 increases your total monthly payments to $2,650, or 49 per cent of your TDSR.
You would be declined.
So what can you do?
Reducing your credit card limits is one place to start. If in the example I had assumed a combined credit limit of only $10,000, total debt servicing would be lower — just over 40 per cent.
You can also ask your bank or credit union to consider re-amortizing your mortgage. By increasing the amortization on your mortgage you will have lower monthly payments, reducing your TDSR.
However, one important point to remember is that a longer amortization means paying more interest. The payoff with this strategy is that if you are re-amortizing your mortgage to allow you to consolidate high interest rate debts, then the savings come from eliminating the total interest cost on high-rate debt.
A good rule of thumb is to repay consolidated debts over no more than 36 months. Once the debt is repaid, you can focus in on repaying your mortgage by changing your payments to biweekly accelerated, which can reduce your mortgage faster.
More importantly, setting up biweekly accelerated mortgage payments automates the process so you don’t have to worry about getting to the bank to make those extra privilege payments of up to 20 per cent of your mortgage, depending on where you bank.
Finally, work with your lender to develop a savings strategy so that you have money in the bank and don’t need to use credit cards in the future. To paraphrase Sir John Templeton, “it is better to be a loaner of money not a borrower of money.”
Remember, you are in control of your financial destiny.
Patrick O’Meara is an instructor and co-ordinator of the financial services diploma program at Red Deer College.