Sunday, October 1, 2017

The Mysteries of Rental Debt Service Calculations

In my post on residential mortgages, debt service calculations for an owner's primary residence were relatively simple to explain.  With rental properties, just trying to understand debt service calculations for can be quite perplexing.  And even if you can understand the calculations, there are quirks in the formulas that don't seem to make much sense.  At least lenders tend to use the same GDS and TDS limits for rental properties as they do for a primary residence.  For GDS that is 32-35%, and 42-44% for TDS.  Unlike the rules for CMHC-insured mortgages, these debt service limits can be exceeded depending on the overall strength of the application.

I'll start with the calculations for someone making their first rental property purchase.  BMO, CIBC, and Scotia all seem to follow CMHC's rules for calculating GDS, even though CMHC does not insure single-unit rental properties.  This means that to calculate Gross Debt Service ratio, half of the rental income will be added to the purchaser's income, then the principal and interest will be divided by that sum.  To calculate Total Debt Service ratio, it is necessary to add the purchaser's other debt service costs, such as primary residence mortgage payment and car loan.  In the spreadsheet above (google docs link) I've done the calculations for someone making a salary of $50,000 per year, with principal, interest, and taxes on their home of $850 per month, and no other debt service costs.  The rental property is being purchased for $200,000, and it rents for $1400 per month with all utilities paid by the tenant.  The results indicate a very low GDS of 19%, and a modest TDS of 36%.

Once more than one rental property is involved, the calculations become much more complicated.  Most lenders use a rental offset calculation for the rental properties you already own, while some (like CIBC) will use Debt Service Coverage Ratio.  Rather than explain the full details here, this Moneysense article does a good job explaining the two.  The spreadsheet above shows a second rental property mortgage for $160,000 with the same $1400 in monthly rent.  The 50% rental offset used by Scotiabank results in a slight increase in TDS from 36% to 38%.  BMO uses a more generous 85% rental offset, which results in a reduced TDS of 34%.

Finally, I'll show how the ratios change for purchasing a 2-unit rental property with a mortgage of $320,000 instead of purchasing two single-unit properties.  If you expect the ratios to be similar, you are in for a surprise.

The GDS has increased from 19% to 33%, and the TDS has gone up to 48%, well above the limits of any banks.  Unless I've made a mistake in my calculations, this means that it is much easier to get two mortgages for $160,000 than it is to get one mortgage for $320,000.  I'd expect banks to prefer one mortgage for $320,000, since processing and administering two mortgages is a lot more work for them.  I doubt lenders will change their rules for debt service calculations, since it is a lot easier for investors to purchase their properties one unit at a time than it is for a large bank to change their underwriting rules.

2017-10-02 Update: I had a conversation with a Scotiabank home financing advisor, and found out that they don't count taxes in their rental offset calculations.  That means the TDS when purchasing the 2nd rental unit would be 36% instead of 38%.

2017-11-18 Update: A TD mortgage advisor recently informed me that they, like CIBC, use a Debt Service Coverage Ratio.

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