Financial Know-How

Since capacity (your ability to make the monthly payments) is usually the biggest determinant in most credit applications, I will focus on this factor in today's post. Specifically, I'm going to show you how you can take the two debt ratios that banks use to gauge capacity, TDS and GDS, and figure out what's the most you will likely qualify for based on your current income and expenses.

As a quick reminder from my previous post "The 5 Cs of Credit" that TDS looks at your overall monthly obligations and GDS looks only at your housing obligations as a percentage of your total gross income (before taxes). Banks want to see these ratios under 40% and 32% respectively. Since you know these two maximum percentages, you can calculate roughly how much you can qualify for.

The easiest way to explain this is to use a simple example. Say you want to buy a car. You have an income of $40000, pay $800 rent, and have a $3000 balance on your credit card (therefore minimum payment is 3% or $90 on credit card). But before going out to look for a car (or a house for that matter), you want to know approximately how much you can qualify for. Here is an easy and effective way to determine that yourself.

From the example, if maximum allowed TDS is 40% of income, then 40% of $40k is $16k or $1333 per month. That means the banks want to see your total overall monthly obligations to be no more than $1333. Since $800 plus $90 is being used to pay for rent and credit card, then the bank will let you borrow up to an amount where the monthly payments is (1333-890=) $443/month. To find out how big that loan is, use a loan calculator that allows you to invert the calculation. BMO has a good one.

So if the bank is currently offering a 4 year loan at 10% interest, then given a payment of $443, you will qualify for a $17,466.67 loan maximum. A 5 year loan with the same rate qualifies you for up to $20,849.96.

A quick check of the GDS shows that 800 / (40000/12months) = 24% so you're below the 32% guideline.


For a mortgage application the calculation for housing costs gets a little more complicated because you have to add in other costs of maintaining the home in addition to the monthly mortgage payment. In a mortgage application, total monthly housing costs  = monthly [mtg pymt + property tax + heating + fire insurance] + 6 months condo fees if applicable. If you don't know these other figures then ask around to estimate it. If you found a home already then the MLS listing and realtor can give you those figures for that particular home. Just minus those totals from the 40% of your income to get the mortgage payment amount and use an invertable mortgage calculator (I'm in the process of finding one for you) to figure out the mortgageable amount or use a normal mortgage calculator and do trial and error to find the mortgageable amount.
 
The calculation above is generally used by all adjudicators in every type of credit application. From credit cards and overdraft protection to loans and lines of credit. Each bank may have different lending policies but they all follow the same 32/40 lending guideline.

One thing I want to remind you of is that capacity is only one of the 5 Cs of Credit that determines how much and whether your credit application gets approved. But it is generally the most important factor in most applications, especially for larger amounts like a mortgage or car loan. Also, some financial institutions may calculate your TDS based on your credit limits and not your minimum monthly payments.