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The missing pieces in banks' real-estate math Add to ...

The debt threat facing this country begins at home.

Mortgages are by far the biggest component of a national debt load that has recently prompted warnings from the Governor of the Bank of Canada and one of the country's largest banks.

Their concerns raise questions about the way in which financial institutions ensure people can afford the mortgages they need to buy a home. Raising a family and maintaining a home require finesse and constant financial manoeuvring. And yet, the housing affordability measures used by bankers are strikingly simplistic.

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In essence, they provide a snapshot of a home buyer's ability to meet his or her basic housing costs and other debts based on gross monthly income. Bankers say these calculations serve them well, but others question how effectively they size up someone's ability to carry the cost of the house through real life's ups and downs.

It's a critical question because these affordability measures are the margin of safety on which the housing market depends at a time when people are paying near-record prices and facing higher mortgage rates ahead.

Look to the United States to see what happens when people suddenly can't afford the home they own. "In the back of our minds, we all worry about the U.S. scenario, where we have large groups of people in society who cannot afford to make the payments on their house," said Moshe Milevsky, a finance professor at York University's Schulich School of Business. "They're under water, they're stuck, and that can lead to larger problems."

1. Evaluating Affordability: How It's Done

The average Canadian two-storey house costs $360,000, so a huge mortgage is inevitable for most buyers.

Two simple, time-tested measures are used by lenders to ensure this debt load is affordable.

The first is called the gross debt service ratio, or GDS. The rule is that monthly housing costs, usually defined as mortgage payments (combined principal and interest) plus property taxes and heating, should not exceed 32 per cent of monthly household income before taxes.

The second measure is called the total debt service ratio, or TDS, and it compares monthly income to housing costs plus payments on lines of credit, credit cards and other debt. Housing costs plus debt payments shouldn't exceed 40 per cent of income.

"I'm 23 years in the business and we haven't really adjusted the debt ratios," said John Turner, national director of specialized lending at Bank of Montreal. "They're tried-and-true guidelines that are proven to work for us in the industry."

The 32-per-cent GDS limit and 40-per-cent TDS limits are definitive enough that Canada Mortgage and Housing Corp., a federal government agency, uses them on its website to help home buyers see if they're financially ready to buy a home. But there are some variations.

Mr. Turner said some lenders will factor 50 per cent of condo fees into the calculation for the GDS, while solid borrowers might be allowed to take their TDS as high as 42 per cent.

Lenders use "five Cs" in analyzing someone's ability to afford a mortgage: capacity to repay, which refers to income; collateral, or the value of the home; character, which factors in things like your record in repaying previous debts and how long you've been at your job; conditions, which refers to economic conditions; and, capital, or the down payment. Mr. Turner said that if someone is weak on capacity but strong everywhere else, a higher ratio may be allowed.

Debt service ratios serve the needs of lenders and are not meant to assure borrowers that their debt loads are manageable, said Jeff Schwartz, executive director of the non-profit Consolidated Credit Counselling Services of Canada. Homeowners may in fact struggle to cover their various monthly expenses, even if they're comfortably onside with the two debt service ratios.

Lenders accept this potential risk because they know people will pay their mortgage while letting other debts slide, Mr. Schwartz said.

"The mortgage is the first thing that gets paid," he said. "People will pay for their shelter first because they're fearful of ending up on the street."

2. Flaws in the System

Assuming you don't eat, have kids or drive a car, the calculations that decide whether you can afford a mortgage should fit you perfectly.

Everyday expenses are not considered when lenders size you up for a mortgage. All they look at is whether payments on an applicant's mortgage and other debts plus property taxes and heat will account for more than 40 per cent of gross household income.

"I have a big problem with the idea that you can spend 35 to 40 per cent of your income on housing and debt because the numbers don't take into account all the other expenses we incur," said Schulich's Prof. Milevsky.

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