Does the type of debt you have matter when applying for a mortgage?

Debt isn’t necessarily bad, despite the negative connotations associated with the word. In reality, being able to manage debt is crucial to not only getting approved for a mortgage but carrying one as well — essentially, you must prove that you can handle payments.

For this reason, lenders scrutinize your credit behaviour and financial obligations using your credit score and debt service ratios to weigh the risk you pose. They want to know if they’ll get their money back someday.

While it’s not foolproof, weighing your income against your monthly expenses can help measure your capacity to make timely payments. What this means, however, is some kinds of debt, particularly those with large monthly payments, can reduce the amount you are allowed to borrow.

Not all debt is the same

There might not be an exact formula for getting a mortgage pre-approval, but one thing is for sure: you’ll need a credit history.

It doesn’t matter if you have an excellent income, says Amanda Lawson, mortgage agent at Rock Capital Investments Inc., a real estate brokerage based out of Orangeville, Ont. “People need to have two years of established credit and two types of credit.” Ideally, the credit limit should exceed $2,000.

Lawson explains that lenders generally need to see two tradelines on your credit report. That means two types of credit extended to a borrower and reported to a credit bureau in Canada. Borrowers with no credit history might require a co-signer to buy property.

Here’s how different kinds of credit or debt can impact your mortgage approval.

Car loans

If you find that your mortgage affordability is low, your car payment might be the culprit.

“About every $400 in payments will roughly impact your mortgage qualifying [amount] by about $100,000,” says Lawson. She explains that, while the balance of your car loan may be modest, the fact that you must make fixed monthly payments, which, depending on the vehicle, might be in the $400+ range, will impact your debt service ratios when applying for a mortgage.

Credit cards

For many people, getting a credit card is a simple introduction to credit, and it can provide lenders with great insights if used responsibly.

Lawson recommends using your credit card “once every season” or about every 90 days to keep it active. Making small purchases can go a long way, so don’t be afraid to use your card. “Buy gas and then pay it off right away,” she says. “If you have payment history, you’re getting credit.”

But be mindful of the balance and ensure you can make your payments. Payments on revolving credit, or products such as credit cards and lines of credit, can vary depending on the loan’s balance. So, unlike an installment loan with fixed payments, your credit card bill will change each statement period.

To account for this, mortgage agents use a percentage of the balance in their calculations.

“For unsecured lines of credit and credit cards, [lenders must] factor in a monthly payment amount corresponding to no less than 3% of the outstanding balance,” according to the Canada Mortgage and Housing Corporation (CMHC)’s website.

This formula helps determine the monthly payment obligation, which can be relatively small on a big credit card balance. Lawson says, “[If] you have $30,000 on your credit card [balance] and a $5,000 car loan, I can get you more house if you pay off your car loan rather than your credit card.”

Still, paying off your credit card balance is essential to avoid accruing interest on the balance.

Mortgage debt and home equity lines of credit

When buying a property, lenders will use your potential monthly mortgage payment, including the principal and interest, when calculating your debt service ratios. This can ensure the home’s purchase price and subsequent mortgage payments are within your affordability.

What people may not realize, however, is that if they have a home equity line of credit (HELOC), lenders factor it in like a mortgage — they don’t use a percentage of the balance.

“If [a person has] a balance on their HELOC, we have to qualify them at 5.25% over 25 years,” says Lawson. This detail can impact those looking for a second home or to co-sign a mortgage for their children.

Student loans

Lenders will calculate your monthly student loan payment or a portion of the entire balance into your ratios under the “other debt obligations” section.

Debt sent to collections

Some of your expenses, such as income taxes owing, are not reported to credit bureaus — unless you default on your payments. In that case, it will appear as a legal judgment on your file. This can be a big red flag to lenders.

“The point of a credit score is to predict whether you will pay your bills on time,” says Julie Kuzmic, senior compliance officer of consumer advocacy at Equifax Canada. “So, if you pay your bills on time, you get a good credit score. That’s the big secret.”

But life happens, and if there are things on your credit file that aren’t great, such as missed payments or items in collections, they won’t impact your credit score indefinitely.

“It may take some time to build back up that credit score, but over time, negative things do have to be removed,” says Kuzmic. “They tend to have a lower impact as they get closer to the removal date.”

If you continue demonstrating bad credit behaviour, your score will go down. In contrast, good credit behaviour can bring it back up over time. However, if you find it challenging to reverse course, seek assistance.

“There are not-for-profit credit counsellors. Don’t be afraid to ask for help and see what resources are available to you,” says Kuzmic.

Child support and spousal support

While child or spousal support is not technically debt, it is another monthly obligation for some.

“If you have to pay $600 a month in child support, that goes into your debt ratios,” says Lawson. “It goes into the liability section.” Lenders will have to factor these payments into the equation if you’re paying them, which can lower the amount you are eligible to borrow.

She explains that receiving spousal support payments, however, can actually increase a person’s income, which could help you afford a bigger mortgage.

How Canadian mortgage agents and brokers determine your debt service ratios

To determine whether you can afford your mortgage payments and other household expenses, mortgage agents and brokers calculate your debt service ratios.

• Gross Debt Service (GDS) ratio: principal + interest + taxes + heat / gross annual income
• Total Debt Service (TDS) ratio: principal + interest + taxes + heat + other debt obligations / gross annual income

The CMHC recommends borrowers not exceed 39% GDS and 44% TDS. The Financial Consumer Agency of Canada’s Mortgage Qualifier Tool is slightly stricter, using a GDS ratio of 32% and a TDS ratio of 40% in its guideline.

If you play with the numbers in the tool, you’ll notice how important income is to the equation.

“You can put an extra $10,000 down to buy a property, and you’ll get another $10,000 in the purchase price,” says Lawson. “But if you increase your income by $10,000, you might be able to increase your purchase price by $40,000.” That’s because you’re able to handle more costs every month.

How your debt and credit behaviour influence your credit score

While debt service ratios show how much debt you can handle each month, your credit score indicates how you’ve managed it in the past and how you’re managing it presently.

“Your credit score is a calculation based on the data that is in a credit report at the time that the score is calculated,” says Kuzmic. “What is in your credit file is not necessarily what your account balance is right now; it is what your balance was the last time it got reported right to Equifax.”

Banks and other lenders report information about once a month to Equifax and TransUnion, the two credit bureaus in Canada. Kuzmic clarifies that this information isn’t reported all on the same day. It generally aligns with your statement that is created.

“As the bureau, we have to be a neutral third party, so we don’t make any lending decisions,” says Kuzmic. “It’s done by each lender that uses the data they get from the credit bureau.”

The calculation is based on several factors, including your payment history, credit utilization, credit history, credit mix, and inquiries. Hundreds of attributes and different pieces of information come from your credit file to create your credit score. However, each lender will use this information in their own way.

“The first thing to know is that there isn’t just one credit score version; there are several credit score versions,” says Kuzmic. “The ingredients are going to be in a slightly different order, but it’s the same ingredients.”

Monitor your credit report

It’s essential to keep an eye on your credit file, know your score and report any errors you might see.

“They’re relatively rare,” says Kuzmic. “But the worst time to find out that there’s an error on your credit file is when you’re trying to deal with a mortgage because real estate transactions can be so time-sensitive.”

Kuzmic advises requesting your file from both bureaus, regardless of it being based on the same information. “You don’t know which score version the lender will use, so it’s important for people to look at both Equifax and TransUnion credit files.” Fortunately, Canadians can do this for free online or by mail.

By making payments on time and managing your credit accounts effectively, you can avoid credit score disappointment when applying for a mortgage. An excellent credit score can help you access the best mortgage rates in Canada and excellent terms and conditions. If you keep your debt service ratios low, you should be pre-approval ready.