Today, I want to discuss the Gross Debt Service Ratio (GDS), the Total Debt Service Ratio (TDS), and the Debt Coverage Ratio (DCR). Now don’t let these fancy terms and acronyms scare you. They are just a little bit of math the banks use to calculate how much they want to lend you money. They’re all important but as far as rentals go, the DCR is the one you want to focus on before buying your next rental property as it will directly affect the GDS and TDS.
I’ll start with explaining how the GDS and TDS work, then I’ll go over how the DCR will affect those numbers. Let’s get into it.
Gross and Total Debt Service Ratios
When lenders look at client affordability, they typically look at two things–the Gross Debt Service (GDS) ratio and the Total Debt Service (TDS) ratio. The GDS ratio is the percentage of your gross income needed to pay for your monthly housing costs including the principal, interest, taxes and heat. You’ll also need to include 50% of your strata/condo fees if you have any. The industry standard is typically 35% so lenders like to see your GDS below this before they qualify you for a mortgage.
(Principal + Interest + Taxes + Heat) / Gross Monthly Income x 100 = GDS (<35%)
The TDS ratio is the GDS ratio plus any additional monthly debts you may have, as well. For example, if you have a $500 monthly car payment, $100 interest payment on a line of credit, and $1000 of alimony, then those get factored in. The industry standard lenders don’t like to see a borrower exceed on their TDS is 42%.
(GDS + All Monthly Debt Obligations) / Gross Monthly Income x 100 = TDS (<42%)
Let’s look at an example:
Dylan has a gross income of $5000 a month. He wants to buy a $450,000 home where the monthly mortgage payment is estimated to be about $1620. The taxes are $280, and heat is $80 a month. He also has a $450 monthly car payment and puts $100 a month towards paying off his credit card.
GDS: ($1620 + $280 + $80) / $5000 = 0.396 x 100 = 39.6%
TDS: ($1620 + $280 + $80 + $450 + $100) / $5000 = 0.518 x 100 = 51.8%
Based on these numbers, Dylan’s GDS and TDS both exceed the industry standard lenders like to see and he would have a hard time qualifying for a mortgage. His options at this point are to opt for a less expensive house, cut his expenses, earn more money or all the above.
These ratios are industry guidelines and not set in stone, so some lenders are more flexible than others. If you exceed these ratios by a wide margin however, there’s a good chance you’ll run into some difficulties getting qualified.
Now let’s say you have a rental property that’s generating income. How does that factor into your GDS and TDS? Does the rental income offset anything? The short answer is yes, but it also depends. This is where the Debt Coverage Ratio (DCR) come in.
Debt Coverage Ratio (DCR)
The DCR is the ratio of rental income vs expenses for a property. For example, if the cost of the mortgage, taxes and insurance is $1000 and the rental income is $1200 then the DCR is $1200/$1000 = 1.2.
Now why do we need to know this and how is it important? First, the higher the DCR the better because that means more cash flow for you. Secondly, and more importantly, the banks look at those numbers when you want to expand your portfolio. When you want to buy more than one rental property, the banks will look at your current portfolio and calculate the DCR. If your DCR is greater than 1.2 – as in, your rent is 20% more than your expenses – then a lot of times, the banks will consider your debt a wash and won’t factor in that cost when they calculate your Gross and Total Debt Service ratios.
Now, what can you do with this information? If you’re planning on building a real estate portfolio over the long term, it’s a good idea to start off with a solid foundation. Start with buying properties with a DCR of at least 1.2, if not better. If it’s below 1.2, some banks will factor in the whole debt into your Debt Service calculation, not just the difference between 1.2 and whatever you may have. Banks will find a way to try to cap you eventually, but it’s your job to figure out ways around it. By keeping to this rule, you can keep growing your portfolio until that happens.
In conclusion, the DCR is HUGE when looking to buy a rental property and can really affect your lending power with banks in how it can affect your GDS and TDS.
Until next time, happy investing!