The Income Tests

When it comes to underwriting a mortgage application, your income is the straw that stirs the drink.

Income has proven to be the lender’s most reliable indicator of loan risk and, as such, the standards set for confirming it are rigorous. Once your exact income has been established, lenders then perform two tests to determine how much money they can safely lend to you. (Note: this explanation assumes that you don’t any additional properties.)

The first income test calculates your Gross Debt Service (GDS) ratio. It takes the following shelter costs and divides them into your gross family income:

• Your mortgage payment, calculated at your approved rate + 2%. (This is referred to as the stress-test, which you can learn more about here.)
• The property taxes for the current year.
• $100/month for heat expense.

The second test, called Total Debt Service (TDS) ratio, takes those same shelter costs and adds the carrying cost of any other outstanding debt that you have on top. That total is then also divided into your gross family income.

Canada’s lenders (and their insurers) have the benefit of decades of mortgage lending experience, and they have used their loan performance data to try to predict how much today’s applicants can safely afford to borrow. Because income has proven a powerful indicator of loan risk, the income tests are sacrosanct.

The Canadian benchmarks for maximum GDS and TDS ratios originate at the high-ratio default insurers and serve as an industry standard that lenders observe.

The maximum thresholds say that your gross debt service (GDS) costs should not exceed 39% of your household’s income, and that your total debt service (TDS) costs should not exceed 44% of your household’s income. Exceptions to extend the ratios a little beyond these levels may possible for mortgages that do not require default insurance, but only if there are strong mitigating factors.

When it comes to providing proof of income, standards depend on your type of employment. If you have been working in a salaried job for at least two years where the majority of your income is guaranteed, then confirming your income can usually be done with a job letter and current pay stub.

If you work on commission or want to include bonus income, lenders will want to see two years worth of income.

If you are self-employed, lenders typically use the income shown on Line 150 of your T1 general. There is some additional flexibility offered by lenders who use “stated income” programs provided that the income needed is deemed reasonable for that line of work. As a general rule, the more unpredictable your income, the less of it lenders are willing to use when conducting their income tests.

The best advice any broker can give a client is to be conservative when stating income. Underwriters are only human, and if they start picking apart an overstated income number they may end up using lower earnings than would be the case if you had been more accurate upfront.

On a related note, an excellent credit score and additional investments which aren’t being used for your down payment are the best mitigants when requesting an income-test exception. If you are maxing out your income ratios, those factors will help to reassure the lender that, one way or another, you meet your debt obligations.

If you are wondering how much your income will allow you to borrow, feel free to check out my online calculator called, “How Much Can I Qualify For?”

While this post provides a general idea of how lenders conduct their income tests, the income confirmation part of the underwriting process is complicated and often involves some back and forth. If your income ratios are tight, partnering with an experienced, independent mortgage broker will maximize your chances for approval and help ensure that your income profile is matched with the lender who is your best fit.

As with any test, it pays to plan ahead.