Written by guest writer Nabil Farah, mortgage specialist @ TD
Translated by Terrie Schauer
Have you ever wondered about your risk tolerance profile?
When investing in real estate, it’s important to understand your income profile and how this affects the types of risks you can and should take with your mortgage financing. With a better appreciation of how risk-proof your profile is, you’ll be able to choose a mortgage product that is right for your situation.
Mortgage markets are increasingly complex, and it’s important to have a macro understanding of your profile and financial situation so that you’ll be able to take maximum advantage of the financing on offer. The amount you can borrow and should borrow is not only linked to your debt ratios.
Do you know if your profile is best suited for conservative or aggressive borrowing?
Here are some factors you should consider:
Depending on your credit score, allowable debt ratios will be between 42% and 44% of your gross income (this includes all debts, car loan, credit card balances, lines of credit etc) and between 35% and 39% of your net salary (for the property you are looking at purchasing, including municipal taxes, condo fees and heating).
If you earn 5,000$ gross each month, your debt service payments must be under 2,200$ and the monthly costs associated with owning the property must not exceed 1,950$. This calculation is call a “Stress Test” created by the Federal government to protect Canadians in the case of an interest rate hike. The Stress Tests are done today based on the higher of two numbers: the Bank of Canada’s Benchmark 5 year rate (fixed today at 5.14%) and the client’s quoted rate plus 2%.
For rental properties, the calculation is a bit different since some banks (including TD Canada Trust) examine each file case-by-case. The good news is that rental income balances out the expenses associated with owning the property in question, either entirely or partially, which allows you more borrowing flexibility.
The type of income you earn is also an important factor to consider.
If you have a stable job with a base salary + commission + bonus, your additional revenue can help you should things become financially strained. Your profile will allow you to get close to the 44% permitted debt ratio.
An aggressive strategy may be a good idea.
However, if you have stable employment but few prospects for a raise or promotion, a more moderate financial plan may be a wiser option.
If your income is 100% commission or you’re an independent worker, a more conservative approach is recommended unless your income-history shows a lot of stability.
Your investor-profile has a lot to do with how you make your income. But banks also look at how you manage your money.
If you have considerable savings, I’d be more comfortable recommending an aggressive approach, since you know how to manage in difficult months.
If you have little or no savings (or if the purchase uses most of your savings), you’ll save time and energy in the future if you opt for a conservative strategy today.
At the start of your career, you have many years of promotions, salary increases, and opportunities to look forward to. Choosing an aggressive plan makes sense for this type of profile. As time goes on, you’ll be able to pay down your mortgage faster and build equity each month.
Closer to retirement, the game changes and you’ll need a different strategy. Even if you can borrow a bit more, budgeting to use your full income each month may not be a good idea. At 58 for example, for a 20-25 year amortization period, it’s wiser to base your calculations on what your revenue will be once you retire.
Wise investors question the risks facing their investments. To assess this information before making a decision, a meeting with a Specialist is always the best option. Especially in a growing and changing market, as is the case in Canada today.
Want to know more?
Come listen to Nabil on Risk Tolerance at our next investor’s workshop in May.