Wednesday, 2 May 2012

Perspective of a First-Time Home Buyer in the Greater Toronto Area (Part 1)

My name is Matthew Teich, and I am in the process of obtaining my Real Estate Sales Representative license. I am also a recent university graduate, and as such, have been seriously considering my long-term future goals. One such goal is to purchase a first home in the Greater Toronto Area, a region in which I am strongly attached. Achieving such a major goal will be a significant challenge, which will take a good portion of time, resources, and preparation. However, the benefits of home ownership, relative to property rental, should far outweigh such challenges over the long run.

The first step to achieving home ownership is establishing affordability. Current household expenses (taken from your budget) and debt payments (i.e. Car Loans, Student Loans, and Credit Cards) are good indicators of current spending patterns. If this level spending is unreasonable, the ability to cover mortgage payments may be compromised. Addressing this spending before considering home ownership is an important step.

There are two important benchmarks that best determine affordability. The first is the Gross Debt Service (GDS) ratio, which is defined as the percentage of income dedicated to essential housing expenses. It is calculated as follows:

        GDS = Monthly PITH / Monthly Gross Income x 100%

PITH refers to the Principal, Interest, Property Taxes, and Heating Costs for a given property. If a condominium is being purchased, this should also include any condo fees. The established rule of thumb is that GDS should not exceed 32%, but this has been known to fluctuate, depending on lender requirements and the buyer's credit-worthiness. 

The second benchmark incorporates monthly debt payments into determining affordability. This is known as the Total Debt Service (TDS) ratio, a value that should not exceed 40%, in order to be considered for a mortgage. The TDS is calculated as follows:

        TDS = (Monthly PITH + Monthly Debt Payments) / Monthly Gross Income x 100%

To better demonstrate the importance of these benchmarks, let's use the GDS as an example. Suppose I make $50,000/year in gross income, which translates into $4,167/month. Assuming a GDS of 32%, we get a PITH of $1,333/month. Again assuming a desired property tax of $2400/year (or $200/month) and a heating cost of $100/month, the maximum blended payment (Principal + Interest) we can afford is $1,033/month. If we qualify for a mortgage with a 25-year amortization at an annual rate of 4%, we get an interest factor of 190.25, resulting in a mortgage valued at approximately $197,000. With a 20% down payment, the highest affordable property price would be $246,250, far too low for the current Toronto market. 

Instead, let's assume a combined family income of $100,000/year, resulting in a monthly gross income of $8,333/month. Again using a GDS of 32%, and the assumed tax and heating expenses above, a maximum blended payment of $2,367/month is found. Using the same mortgage criteria and down payment percentage, the highest affordable property price would be approximately $563,000. This is well within the range of listed home prices in Toronto.

Keep in mind this is a rough calculation of affordability, with a number of uncertain assumptions. For instance, property tax will fluctuate, depending on the assessed value of the owned property, as well as the tax rate charged per year by the city. You could determine, by trial and error, the property tax best associated with the final affordable property price, but this is more effort than necessary. It is better to have sufficient resources available to offset such risk.

We will later discuss establishing a mortgage in greater detail, as well as the various up-front costs associated with purchasing real estate.