What is a debt-to-income ratio?

And will debt-to-income ratio caps be introduced in NZ?

In amongst the sometimes-emotional talking point that is the NZ property market, the latest development is the possible introduction of debt-to-income ratios (DTIs) for new mortgage lending.

What is a DTI?

Keeping debt at a manageable level is important for good financial health. Your debt-to-income (DTI) ratio is a financial measure that is used by lenders when you apply for lending. It compares the amount of debt you have to your overall household income.

As an example, say you are a couple and have:

• A home loan of $600,000, a personal loan of $12,000, credit card debt of $5,000 and Afterpay debt of $3,000.
• Annual earnings of $85,000 each before tax.

This takes your total liabilities (debts) to $620,000 while your combined gross annual household income is $170,000. Your DTI ratio would therefore be 3.64 ($620,000 divided by $170,000).

DTI ratio limits are not currently part of the banking regulator’s (Reserve Bank’s (RBNZ)) toolkit and would require approval through an official process before becoming enforceable. If it does become an assessment tool for the lenders, a simple example could be:

DTI ratio of five. Based on the income above, you may be able to borrow up to $850,000 ($850,000 divided by $170,000).

While the banking regulator does not have a mandate to target house prices directly, its financial policy tools could help ensure housing prices do not deviate too far from sustainable levels.

Could DTIs mean one size fits all?

Over recent years, we have seen how simple policy statements about housing and mortgage lending can become complex in application, including areas such as the latest changes to bright-line tax (capital gains tax) and the recent announcement on interest deductibility on investment properties leading to a 143-page consultation paper.

Obvious practical concerns with DTIs could mean they make the home lending process even more burdensome. If introduced, rigid implementation of DTIs across the banks would not allow lenders to take their varying lending capacity and risk appetite into account. Topics to be overcome would include:

• Though announcements have been made suggesting that any DTI’s should be designed to avoid impact on first home buyers, it’s difficult to see how that could be worked through. That’s because the wealthiest Kiwi’s on high incomes might be the least impacted, while those on lower incomes, including first home buyers, could be the most to struggle. The wealthiest group would include many property investors, who have been targeted lately as culprits of NZ’s housing affordability woes.
• How income from sources such as tenants or boarders is included in the overall income figures. The same goes for income from other investments such as dividends from shares.
• What is counted as debt? For example, student loans or consumer debt such as credit cards.
• What about how people spend? Due to lifestyle creep, someone with an income of $150,000 could have a monthly surplus of $1,000, while someone with an income of $75,000 could be spending less on lifestyle expenses and might have a surplus of $2,000 per month.

The property issue is still unresolved

NZ’s housing prices have been increasing at rates faster than income growth for years, meaning it is getting tougher and tougher for first-time buyers to get into the market. Homeownership is seen as a right for hardworking Kiwi’s, and as homeownership is a cornerstone of wealth and financial stability for most NZ families, it is understandable that housing affordability has become a hot topic.

In the broadest terms, a DTI would just be further government intervention in a heavily regulated environment. This detracts from the key issue; regulation hindering land supply, which is now made worse by a lack of materials and builders, and chronically low interest rates.

Learn more: Why do cities become unaffordable?

Other nations have DTIs

It’s worth noting that other countries have DTIs, sometimes combined with a ‘speed limit’.

For example, in the United Kingdom (UK), banks can only advance up to 15 percent of the number of new mortgages at a DTI ratio greater than 4.5. Many readers will already know that the DTI ratios in the UK still haven’t stopped London from becoming one of the most expensive cities in the world to buy a home!

The UK rules do not apply to investors, probably at least in part because nailing down the relevant income for this buyer group is difficult. Intriguingly, NZ government consultation documents from a few years ago suggest that DTIs in NZ could potentially be applied to both owner-occupier and investor loans. Although there may be exemptions for new-build property or very low value purchases.

What will happen next?

The banking regulator will consult lenders before adding DTIs to its regulatory toolkit.

The regulator has clearly stated that there is no immediate plan to use DTIs, and any decision to do so would only happen after a full public consultation. The government has already put in place several measures to cool the housing market and the regulator has said it's important to give these initiatives time to assess their impact.

It’s all about mortgage serviceability

Currently, for most borrowers with a large enough deposit (or enough equity for those who already have lending), banks’ assessment of their loan servicing ability is already the most important driver of the maximum amount that can be borrowed. Banks typically use a net income surplus test for originating mortgages, which is designed to ensure customers will have enough residual income after mortgage and other commitments to meet their living costs. Banks also already factor-in the potential for interest rates to rise into this equation.

The bottom line, debt to income ratios

Any individual tool is unlikely to have an impact on NZ’s housing market. However, the combined effect of all the recent government initiatives could start to slow house price growth. Even so, the fundamental drivers of housing unaffordability in NZ remain, so the trend for property prices is likely to continue to steadily march upward.