Calculation of Debt Service Ratios: Treatment of Key Inputs
Effective July 2012, the Government of Canada fixed the maximum Gross Debt Service and Total Debt Service ratios for insured mortgage loans. This change reinforced the importance of ensuring that debt service ratios provide the same measure of a borrower’s ability to service the mortgage debt, regardless of the lender submitting the application to CMHC for insurance.
CMHC has collaborated with many mortgage lenders to clarify the treatment of key inputs included in the calculation of debt service ratios and minimum documentation requirements for all CMHC-insured homeowner loans. The clarifications include:
Income
Supporting documentation confirming income, employment status and income sustainability are required for all borrowers. Reasonable inquiries should be made and reasonable steps taken to obtain third party verification of the underlying income for all borrowers. This includes substantiation of employment status and income history.
Variable Income:
The variable income level must have been sustained over at least two years and mortgage professionals are to use an amount not exceeding the average income of the past two years. Examples of variable income include bonuses, tips, seasonal employment, investment income, etc.
Where income is increasing year-over-year for four years or more, income for the most recent year may be used. Where income is declining from one year to the next, due diligence is expected to be applied and account for the downward trend.
Self-employed Income (without traditional documentation to support income verification)
Borrowers who have recently become self-employed or operate a new business may have difficulty providing traditional forms of documentation to support income. Reasonable steps are expected to be taken to obtain standard documentation to support gross annual income. Where traditional income documentation is not available, a reasonable effort must be made to assess the plausibility of the income, including consideration of the nature of the self-employment, reported by the borrower before submitting the application to CMHC. Relying solely on borrower disclosure is not acceptable.
Rental Income
Where gross annual income includes rental income from a property that is: not owner-occupied; and not the subject of the current insurance application, the principal, interest, property taxes and heat (P.I.T.H.) of the rental property expenses must either be:
- deducted from gross rent revenue when establishing net rental income; or
- included in “other debt obligations” when the Total Debt Service (TDS) ratio is being calculated.
Guarantor Income
Guarantors'/covenantors' income must not be used for the purpose of satisfying CMHC's borrower qualification criteria unless the guarantor/covenantor occupies the home and is the spouse or common-law partner of the borrower.
Debt
Unsecured Lines of Credit and Credit Cards
For unsecured lines of credit and credit cards, an amount corresponding to no less than 3% of the outstanding balance is to be factored in. In determining the amount of revolving credit that should be accounted for, reasonable inquiry is expected to be made into the background, credit history and borrowing behaviour of the prospective borrower.
Secured Lines of Credit
For secured lines of credit, an amount corresponding to at least a monthly payment on the outstanding balance amortized over 25 years using the contract rate or the 5-year Benchmark rate (V121764) published by Bank of Canada (if contract rate is unknown), is to be factored in. Approved lenders may elect to apply internal guidelines where the result is at least equivalent to the above.
Heating Costs
Reasonable effort is expected to be made to obtain actual heating cost records for the subject property. Where there is no history of heating cost available for the subject property, the heat expense used for calculating debt service ratios must be a reasonable estimate taking into consideration factors such as property size, location and/or type of heating system.
As per CMHC’s current expectations with regards to approved lenders’ responsibilities, approved lenders may continue to impose underwriting policies that are more stringent than prescribed by CMHC and, subject to reasonableness and prudency, observe their own conventional lending practices in the absence of CMHC policies on a specific issue.
To allow adequate time for the industry to apply the approach, the clarifications will become effective on December 31, 2013.
Source: CMHC
