The article “Could a line of credit impact my mortgage application?” was originally published in MoneySense on November 16, 2021. Photo by Sarandy Westfall on Unsplash.
Line of credit payments and other non-mortgage debt are factored into mortgage affordability calculations. Here’s what you need to know before filing your mortgage application.
Prospective house hunters and those looking to refinance an existing mortgage should consider the impacts of their lines of credit on their mortgage application. That’s because lenders take non-mortgage debt, including line of credit payments, into account when determining how much you can afford to borrow.
How a line of credit affects a mortgage application
Lenders consider factors like a borrower’s creditworthiness, income and existing debt before lending them money.
When it comes to mortgages, they want to know what percentage of your income will be spent on housing costs, to ensure you can afford your future mortgage payments. This is called the gross debt service ratio (GDS), and it is based on your mortgage principal and interest, taxes, heating costs and condo fees (if applicable) divided by your income.
But lenders also want to know that you will be able to pay your mortgage in addition to all your other existing debt. To figure this out, they use what’s called the total debt service ratio (TDS). It is calculated by adding other debt obligations, such as a line of credit payments, to the expenses already included in the GDS formula, and then dividing by your income.
For many home buyers, paying down a line of credit may improve the borrower’s TDS. By paying off the line of credit, their debt-to-income ratio drops, and this increases the amount they can borrow on a mortgage. In other words, paying down a line of credit can increase your mortgage affordability.
In July 2021, the Canada Mortgage and Housing Corporation (CMHC) reintroduced pre-COVID underwriting practices for homeowner mortgage insurance typically required for purchases in which the borrower has less than a 20% down payment.
Specifically, CMHC requires:
- At least one of borrowers on the mortgage to have a credit score of 600 or more. The same applies to a guarantor for the borrower(s).
- A borrower’s gross debt service (GDS) ratio to be under 39%.
- A borrower’s TDS ratio to be under 44%.
The “other debt obligations” part of the formula can have an impact on first-time homebuyers or those with down payments of under 20%—specifically, an increase in TDS ratio may reduce the size of a mortgage approval. But even those with large down payments may face limits on how much they can borrow when they carry a lot of non-mortgage debt.
The impact of a line of credit on mortgage affordability
When calculating a borrower’s debt service ratios, CMHC includes other debt obligations, such as revolving credit (i.e. credit card debts and lines of credit), personal loans and car loans. Those debt obligations are factored into mortgage affordability differently, depending on whether they are secured or unsecured.
According to CMHC:
For unsecured lines of credit and credit cards, factor in a monthly payment amount corresponding to no less than 3% of the outstanding balance. In determining the amount of revolving credit that should be accounted for, lenders should ensure that they make a reasonable inquiry into the background, credit history and borrowing behaviour of the prospective borrower.
For secured lines of credit, factor in an amount corresponding to at least a monthly payment on the outstanding balance amortized over 25 years using the contract rate (or the benchmark rate if contract rate is unknown). Lenders may elect to apply their own internal guidelines where the result is at least equivalent to the above
Lenders typically register a collateral charge against the property for the amount of the line of credit you were approved for, and the collateral charge could be as high as the appraised value of the property or more. This is done so you can more easily increase your borrowing in the future without having to incur legal fees.
A borrower who is trying to improve their credit score should consider that about 30% of the calculation is attributed to what’s called credit utilization, according to Equifax. That is the ratio of credit balances to credit limits.
Credit utilization of less than 30% is considered ideal, which means you want your credit balances to represent less than 30% of the total credit available to you. If your line of credit or credit card balances approach those limits, it could reduce your credit score or prevent you from improving it. If you find yourself in that situation, you should try to improve your ratios by paying down debt.
Can you borrow money for your down payment?
You can borrow money for a down payment, but lenders will generally require a minimum amount of the purchase to come from your own sources. For home purchases under $500,000, the minimum is 5% of the purchase price. For homes over $500,000, the minimum increases to 10% of the purchase price.
Besides being risky, borrowing on an unsecured line of credit for a home down payment can end up costing you more, because line of credit rates are typically higher than mortgage rates. Unsecured lines of credit may range from 5 to 10% interest, but secured lines of credit backed by real estate equity can be as low as the prime rate (currently at 2.45%).
Should you consolidate your line of credit into your mortgage?
When a borrower applies for a mortgage, it can be an opportunity to consolidate debt and reduce interest costs.
If a borrower has an existing line of credit that can be paid off with their mortgage, doing so can likely lower their borrowing costs. Even when renewing a mortgage with the same lender, you should consider rolling a line of credit balance into the mortgage. It will increase your payments or your amortization, but it will reduce the interest rate you are paying for the line of credit principal.
If a homeowner is consistently running up a line of credit balance—a concerning long-term trend—they should look at their spending to see why their expenses are exceeding their income.
A final word of advice
A borrower who has been pre-approved for a mortgage should be careful about changes to their other debts before finalizing their mortgage. An increase in balances, credit limit or missed payments could have an impact on the potential mortgage advance. Some lenders may require a line of credit or credit card to be paid out or closed prior to approving a mortgage. You should clarify this during the pre-approval process and well before your closing date.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.