Getting pre-approved for a mortgage is like asking your lender to go steady. It’s kind of a big deal. If you want a mortgage lender to swipe right on your application then you need to make sure you are mortgage material. That means educating yourself and understanding how the pre-approval process works.
If you think house hunting starts with private showings and Sunday afternoon open-houses, you’ve already started off on the wrong foot. Getting all your ducks in a row before you apply will prevent you from getting your heart broken later on.
Once you’ve been pre-approved for a mortgage you’ll know your price range. Now the fun of house hunting can begin. Not to mention, most real estate agents won’t even start showing you homes until you’ve been pre-approved.
Once your lender has said “I do” to your mortgage application, you have the freedom to move quickly and snag that perfect home the second it hits the market.
Clean Up Your Credit
In Canada, the bare minimum credit score required to qualify for a mortgage is 600. However, basement-level credit scores come with sky-high interest rates. If you want to get approved by one of Canada’s big five banks at a competitive interest rate, you’re looking at a credit score of 680 or higher.
A strong credit score is made up of on-time payments, up-to-date credit accounts, minimal debt balances, and clear of collections or judgements. A strong credit score will boost your chances of pre-approval and it can literally save you tens of thousands of dollars in interest. Don’t believe us? Here’s an example:
Let’s pretend you have a credit score of 600 and one of Canada’s major banks pre-approves you for a $350,000 mortgage at a 3.5% interest rate amortized over 25 years. Assuming your rate and payment never change, you will end up paying over $175,000 of pure interest.
Now let’s say your credit score is 595 and a private lender pre-approves you for the same $350,000 mortgage amount over a 25 year amortization period but for a slightly higher rate at 4%. Over the life of your mortgage, you will end up paying over $204,000 in interest.
In this scenario, a lower credit score bumped your interest rate by just half a percent which cost you almost $30,000 in additional interest. Yikes!
If you have some blemishes on your credit file that are tanking your score below 680, you should really work on cleaning it up so you have the best possible chance of getting pre-approved for a mortgage at the best possible rate.
Start by settling up any collections or past due accounts, pay down your credit card balances and make all of your payments on time every month.
Compare Mortgage Interest Rates
Before booking your pre-approval appointment you should shop around for the best mortgage for your needs and compare interest rates first. Knowing ahead of time who’s offering the lowest mortgage interest rates will help you narrow down where you’d like to do business.
The best place to start is with an online comparison site like Hardbacon. Just answer a few quick questions about the type of property, your price range and how soon you plan on re-selling. Then Hardbacon will generate a list of lenders offering the most competitive mortgage interest rates, the term, and monthly mortgage payment.
Keep in mind, you’ll need a pre-approval appointment to not only find out if you actually qualify but also your exact rate and a more accurate mortgage payment estimation as well.
A great strategy is to use both an online comparison tool and a mortgage broker. Each will have partnerships with different lenders that they work with. Using both will give you an excellent picture of all the different lenders out there and what they’re offering. If you aren’t a typical buyer because you are self-employed or have a weaker credit file with a past bankruptcy, for example, a broker can help connect you with alternative lenders who take on more risky homebuyers.
Book A Mortgage Pre-Approval Appointment
Now that you’ve narrowed down the list, you need to call and book a pre-approval appointment with your lender of choice. In this appointment, the lender will assess your financial profile to determine how much of a mortgage you can afford, as well as the interest rate. If you’re approved, your rate will be locked in and guaranteed anywhere from 60-130 days.
At that point, you can start contacting real estate agents to begin house hunting. Since the rate is guaranteed for a specific timeframe, you’ll have peace of mind knowing you won’t get hit with any surprises should the rates increase while you’re trying to find the perfect home.
The pre-approval process is faster and easier the more prepared you are. Since the lender needs to assess your full financial profile, you’ll need to make sure you have all the required documentation ready to go. To get started, you’ll need:
- Photo Identification: Like your driver’s license or passport. If you’re using your passport, be prepared to provide secondary documentation like a utility bill or bank statement with your name and address on it.
- Social Insurance Number: In order to pull your credit file to assess your history and creditworthiness, your lender will need your Social Insurance Number. If you’ve ever applied for credit in the past then you know this is standard practice. Your SIN is used to ensure the correct credit file has been pulled. There are 8 billion other people on the planet; somebody is bound to have the same name as you but none of them will have your unique SIN number. This will help avoid any errors or hiccups that could slow down or complicate the application process.
- Financial Documents: You’ll need your banking and investment statements, pay stubs, employment verification letters, tax returns and sometimes your Notice of Assessment if you’re self-employed or have additional income streams. You also need to provide other documentation proving your assets and liabilities like cars, boats or cottages, as well as all your debt, like credit cards, lines of credit, student loans, etc.
- Proof of downpayment: Some new home buyers may not be able to afford a down payment by themselves. It is not uncommon for parents to help their children with the purchase of their first home. If that applies to you, you’ll need a letter declaring that the funds for the down payment are a gift and not a loan.
The Mortgage Stress Test
When lenders are deciding whether or not to pre-approve you for a mortgage, they’re not just looking at your credit score and how much money you make. They’re also running careful calculations to make sure you can afford the mortgage, the associated costs of homeownership, and the general cost of living.
Federally regulated lenders, like Canada’s big 5 banks, are legally required to make sure you can afford your mortgage payment with the interest rate they’re offering you, as well as a pretend higher rate. This is called the mortgage stress test and it’s designed to make sure homebuyers can still afford to make their mortgage payments should interest rates rise in the future. Believe it or not, this is for your own protection. You don’t want to lose your house and the bank doesn’t want to take it. The mortgage stress test is meant to help protect all parties involved.
The stress test looks at your ability-to-pay, commonly known as your debt-to-income ratio, and runs it through two equally important calculations:
Gross Debt Service Ratio (GDS)
Your Gross Debt Service (GDS) is your total before-tax monthly income measured against your potential mortgage payment, property taxes, utility bills and condo fees (if they apply). Lenders are looking for a total GDS score of 32% or less. That means, for every dollar you make, you should not be spending more than $0.32 on your cost of housing.
Total Debt Service Ratio (TDS)
Your Total Debt Service (TDS) measures your total before-tax monthly income against your housing costs plus all your other monthly debt obligations like student loans, cars, credit cards, etc. Lenders are looking for a total TDS score of 42% or less. That means that for every dollar you earn, you should not be spending more than $0.42 on housing and all your other debt.
The percentage of your monthly income you spend on housing and debt obligations plays a critical role in whether or not you qualify for a mortgage. Generally, your debt-to-income ratio will fall into one of the following risk categories:
Good: 32% or lower
High Risk: 43-49%
Dangerous: 50% or higher
So what does this have to do with the stress test?
Federally regulated lenders (like Canada’s big 5 banks) are legally required to run a “worst-case scenario” test to make sure you can handle a higher mortgage payment should interest rates rise in the future.
Remember, rates are not locked in for the life of your mortgage, they are only locked in if you choose a fixed-rate term mortgage, which is usually between 2 and 5 years. Of course, if you choose a variable-rate mortgage then your payment is subject to the constantly changing interest rates and will fluctuate month to month. But let’s get back on track.
If you’re applying for a high ratio mortgage, which means your down payment is less than 20% of the purchase price (common among first time home buyers), then the bank has to run the numbers to see what your mortgage payment would be if the interest rate were to increase from the current rate to a hypothetical rate of 5.25%.
If you’re applying for a conventional mortgage, which means you are able to make a down payment of 20% or more of the purchase price, the bank will run the same stress test but with your negotiated rate plus 2% or 5.25%, whichever is higher.
The bank then has to compare that fictitious payment against your current debt to income ratio. If that higher payment pushes your GDS or TDS over 32% or 42% respectively, you’ll be considered higher risk and will likely be charged a higher mortgage interest rate.
Now, if you apply for a high ratio mortgage by giving only the minimum down payment of 5%, you are required to have mortgage default insurance through the Canadian Mortgage and Housing Corporation (CMHC).
They insure the bank against loss in case you default on your mortgage, and the banks pass those premium costs on to you. And since CMHC is insuring your mortgage, there is no wiggle room here for the stress test. It’s a hard pass or fail. CMHC will not approve mortgages that are at a very high risk of default. A minimum 5% down payment and a TDS over 42% are a recipe for disaster.
If the stress test pushes you over the ideal limits of either the GDS or TDS, you won’t be approved for a mortgage through a traditional lender. You may have to consider applying with a credit union, private or alternative lender. But they typically charge much higher mortgage interest rates.
The Mortgage Stress Test: A Case Study
You’re applying for a joint mortgage with your significant other. You both make the Canadian average salary of $52,000 a year each which puts your gross monthly household income at roughly $8,700 a month. You’re applying for a $350,000 mortgage and your bank pre-approved you at 3.75% over a 25-year amortization.
Your mortgage payment would be about $1,800 a month. Together, you and your partner are paying $1,300 a month to debts like your student loan, car and a few small credit cards. The property taxes are estimated at $3,500 a year ($292 a month) and a house of this size typically costs an average of $200 a month in utilities.
This mortgage payment coupled with property taxes and utilities gets subtracted from your gross monthly income. That puts your Gross Debt Service ratio at 26%. That means for every $1.00 you make you are paying $0.26 to your potential housing costs. Great! That means you passed the GDS test.
But now the bank has to factor in all your other monthly debt obligations like your student loan, car and credit cards. Your monthly debt payments are added to your potential monthly housing costs which put your Total Debt Service ratio at 41%. Fantastic! At the mortgage interest rate of 3.75% your bank has offered, you’re pre-approved (kind of).
You’re not out of the woods Yet!
You were only able to give a 5% down payment. That means you’re applying for a high-ratio CMHC mortgage. The bank has to apply the qualifying rate of 5.25% to the exact same mortgage amount and amortization period. At that rate, your mortgage payment would be $2,100. Now your Gross Debt Service is 30% and your Total Debt Service Ratio is 45%.
You just failed the CMHC stress test all because of a mere $300 difference between the two mortgage payments. That’s why it is so important to pay down as much debt as possible before applying for a mortgage.
The debt you’re carrying can quite literally be the deciding factor in whether or not you qualify for a mortgage even if you have perfect credit.
So now your options are to put off buying a house until you can pay down your debt, adjust your price range and apply for a smaller mortgage, or you can keep saving until you can provide a 20% down payment.
But let’s be realistic: in some housing markets that’s not always possible.
Can You Avoid The Mortgage Stress Test?
You can, but you shouldn’t.
Since Canada’s Big 5 Banks are federally regulated they are legally required to apply the stress test to your application.
However, credit unions, private and alternative lenders that are not federally regulated don’t have to run the stress test. Having said that, you’ll be hard-pressed to find a credit union that doesn’t use the stress test as part of their approval process.
Because it’s just good business. It ensures they are granting mortgages to those who can truly afford them. It’s also because credit unions are risk-averse.
They don’t like taking chances. Credit unions are less willing to take on riskier mortgage borrowers for the simple reason that they are considerably smaller than banks, loss hits their bottom line significantly harder. In order for them to stay in business, they need to remain profitable and must be extra careful when lending.
However, other private lenders, like subprime mortgage companies, do not have to follow stress test guidelines either. But since they take on much riskier applicants, their mortgage interest rates are astronomically higher. It’s not uncommon for private lenders to charge mortgage interest rates in the double digits.
If the only way you can obtain a mortgage is to go through a private or subprime lender, you really shouldn’t be getting a mortgage at all.
That’s a really tough pill to swallow, but the truth hurts sometimes.
What Your Mortgage Pre-Approval Means And What It Doesn’t Mean
Once you’ve received your pre-approval for a mortgage, it’s important to understand what it does and doesn’t mean when it comes to buying a house.
If you’re approved, it means the lender has confirmed you meet the basic credit requirements and you passed the stress test. It also means you are guaranteed a specific interest rate for a specific period of time.
It doesn’t mean that the house of your dreams will automatically be approved. Once you find a house and submit an offer, that’s when the real financial heavy lifting starts. Lenders have very specific parameters around what kind of properties qualify for a mortgage and which properties don’t. Here are a few things that can kill your mortgage approval:
- Value: In order for a lender to approve your mortgage, the property needs a professional appraisal to ensure the list price reflects the true value of the property. It’s not uncommon for an appraisal to come in under the list price.
- Property Type: Not all lenders finance all properties. For example, some lenders won’t finance mobile homes older than 1985, while others just won’t finance them at all. Some have other stickler requirements about whether or not it’s on wheels or a foundation. And, despite their growing popularity, banks won’t finance a tiny home with a traditional mortgage. Those require an entirely different kind of loan altogether
- Location: Lenders also have stipulations on where the property can be located. If your lender is a credit union, for example, depending on the size and number of branches they may not finance mortgages outside a certain radius from where they are located, known as the trade area. Since credit unions are provincially regulated, meaning they cannot operate outside their respective province, an Ontario based credit union cannot finance a mortgage for a house in Alberta or BC, for example. If your lender pre-approved you for a mobile home, there may also be restrictions about the land. Many lenders will not finance mortgages for mobile homes on land you don’t own. So if the land is leased, your financing could fall through. Still, others won’t finance properties on lakefronts or in regional parks.
Just like any other relationship, honesty is the best policy, and when it comes to your financial profile, good character is next-level sexy. It’s not just about ticking the right boxes like good credit and stable income. There are important aspects of your financial situation that fall outside the scope of your application.
You need to be honest not just with the bank, but with yourself too. Do you struggle with overspending? Are you planning on changing jobs? Are there rumours of company-wide layoffs? Would you like to have children in the future?
These are the kinds of serious questions you need to ask yourself before you pop the question by submitting an application. Getting married can be scary, but getting mortgaged shouldn’t be. As long as you are honest, committed and ready to put in the work.
There’s a lot to be said about an applicant who has dedicated considerable time and energy to rehabilitating their credit file and preparing for the serious financial commitment of homeownership. Do that, and any lender would be lucky to have you.