Definition:
The Total Debt Service (TDS) ratio is a key metric used by lenders to assess a borrower’s ability to manage their debt load in relation to their income. It measures the percentage of a borrower’s gross income that goes towards paying all of their debt obligations, including the mortgage, credit cards, car loans, and other debts. Lenders use the TDS ratio to determine whether the borrower can afford to take on a new mortgage or loan, ensuring that they are not over-leveraged.
How the TDS ratio works
The TDS ratio is calculated by dividing a borrower’s total monthly debt payments by their gross monthly income. The result is then multiplied by 100 to get the percentage. The formula for calculating the TDS ratio is:
For example:
- If a borrower’s total monthly debt payments (including their mortgage payment, credit card payments, and other loans) are $3,000, and their gross monthly income is $6,000, their TDS ratio would be:
This means that 50% of the borrower’s gross income is going towards debt payments.
Why the TDS ratio is important
The TDS ratio is an important tool for both lenders and borrowers:
- For lenders: The TDS ratio helps lenders assess the risk of lending to a borrower. A high TDS ratio indicates that a borrower is already committed to a large portion of their income for debt repayment, which could make it more difficult for them to take on additional debt. Lenders generally prefer borrowers with lower TDS ratios, as they are seen as less risky.
- For borrowers: The TDS ratio provides a clear picture of how much of your income is going toward servicing debt. A high TDS ratio can signal that you might be over-leveraged, which could affect your ability to meet future financial obligations or qualify for additional loans.
Components of the TDS ratio
The TDS ratio includes all of the borrower’s monthly debt payments, not just the mortgage. Common debts that are included in the TDS ratio calculation are:
- Mortgage payments: This includes the principal and interest portion of your mortgage payment.
- Property taxes: If property taxes are included in your mortgage payments, they are factored into the TDS ratio.
- Heating costs: If your heating costs are included as part of your monthly housing payment, they are also considered in the TDS calculation.
- Other debts: Any other monthly debt obligations, such as car loans, credit card payments, student loans, personal loans, or other revolving credit balances, are also included in the calculation.
How lenders use the TDS ratio
Lenders use the TDS ratio as one of the primary tools to determine whether a borrower can afford a new mortgage. Generally, the lower the TDS ratio, the more likely it is that the borrower will be able to meet their monthly mortgage and other debt obligations. While the exact threshold can vary by lender and type of loan, a typical acceptable TDS ratio for mortgage borrowers in Canada is:
- Normal TDS ratio limit: Most lenders look for a TDS ratio of 40-44% or lower, meaning that no more than 40-44% of the borrower’s gross income should be going toward debt repayments.
- High TDS ratio: If the TDS ratio is higher than the lender’s threshold, the borrower may not qualify for the loan, or they may be offered a smaller mortgage amount or higher interest rates.
TDS ratio vs. GDS ratio
The TDS ratio is often compared to the Gross Debt Service (GDS) ratio, which is another metric used by lenders to evaluate a borrower’s ability to handle their mortgage. The main difference between the two ratios is that the GDS ratio only considers housing-related expenses, such as the mortgage payment, property taxes, and heating costs. The TDS ratio, on the other hand, includes all debt obligations, providing a more comprehensive view of the borrower’s financial situation.
- GDS ratio: The GDS ratio typically should not exceed 32-39%, depending on the lender.
- TDS ratio: The TDS ratio typically should not exceed 40-44%, depending on the lender.
While both ratios are important, the TDS ratio gives a broader picture of a borrower’s overall debt load.
How to improve your TDS ratio
If your TDS ratio is higher than desired, there are several strategies you can use to improve it:
- Pay down existing debt: Reducing your credit card balances, car loans, or other debt will lower your total monthly debt payments, improving your TDS ratio.
- Increase your income: Earning more income can help reduce your TDS ratio, as it increases the denominator of the calculation.
- Refinance existing loans: Refinancing loans at lower interest rates or extending loan terms can reduce monthly payments, thereby improving your TDS ratio.
- Avoid taking on new debt: Before applying for a mortgage or loan, try to avoid taking on new debt that will increase your monthly payments.
How to calculate your TDS ratio
To calculate your TDS ratio, follow these steps:
- List your monthly debts: Add up all of your monthly debt payments, including your mortgage payment, property taxes, heating costs, car loans, credit card payments, student loans, and any other debt obligations.
- Determine your gross monthly income: This is your total income before taxes and deductions, including your salary, rental income, business income, and any other sources of income.
- Calculate the TDS ratio: Divide your total monthly debt payments by your gross monthly income and multiply by 100 to get the percentage.
For example:
- If your monthly debts total $2,500 (including mortgage, car loan, and credit cards) and your gross monthly income is $6,000:
This means that 41.67% of your income goes toward debt repayment.
Last modified: November 12, 2024
