When mainstream lenders approve a mortgage application, it means they’ve done enough due diligence to know the borrower has a low likelihood of non-payment.
One common method lenders use to size up borrowers is debt ratio analysis. They do this by assessing how much of your gross monthly income is spent on debts each month, including housing costs.
The lowest interest rates in Canada require a total debt service (TDS) ratio of 44% or less.
Debt ratio analysis is key to knowing how able a homeowner is to withstand financial shocks, like loss of employment, serious illness, divorce and surging interest rates. That’s why the government imposed its infamous new “stress tests” on the mortgage market in 2016 and 2018.
Other things equal, the greater your debt ratio, the more likely you are to default.
But that relationship doesn’t always hold.
Fitch Ratings recently put out a recent report analyzing default triggers. It shows something interesting.
Rates are based on a $300,000 mortgage.
While the borrower’s total debt burden relative to income can be an important predictor of default, most borrowers with TDS ratios above the normal 44% limit actually tend to have lower probabilities of default than “bank-worthy” borrowers in the 35-44% range.
"The 45+ TDSR bucket has lower observed cumulative default rates because 45+ TDSR loans generally have lower LTVs and higher FICO [credit] scores,” Fitch explained.
People with gobs of equity don’t like losing all that equity, and non-prime specialty lenders like Home Trust and Equitable Trust know it. That’s why many alternative lenders lend to people with debt ratios well above 44%, as high as 60%+. The lender knows full well that it’s highly likely to get its money back.
Now, that’s not to say high TDS borrowers aren’t risky. There’s a reason lenders charge them 100 to 200+ basis point higher rates. They stiff their lenders more often than AAA prime borrowers. But fortunately, these non-payers almost always have enough equity that when they default, the lender can recover virtually all its losses in a reasonable timeframe.
So, if you have a temporarily high debt load but lots of home equity and/or a great credit score, all too many lenders will be lining up to loan you money. The fact is, conventional wisdom (that high debt loads = high risk) is frequently wrong.