Debt to Income Ratios: What Are They and How Are They Measured?

On 16 June 2021, the Government announced that the Reserve Bank has been given the authority to use debt-to-income lending restrictions as another tool in the toolbox to help settle the property market. The Reserve Bank has said that they have no immediate plan to use debt-to-income ratios. If they do look at using them, they would only do so after a public consultation process. Any change would be designed to impact investors rather than first home buyers. So, it’s a wait-and-see situation for now. 

The information in this article is current as of 17 June 2021.

How are debt-to-income ratios measured?

Debt-to-income ratios can be measured in two ways – an easy way and a hard way. Or rather, an easy-to-follow way and a say-that-again way.

So, the easy way. The DTI ratio is found by multiplying your household income by x to determine the maximum amount you could borrow. So, if the Reserve Bank mandated a maximum DTI of 5 you would then be able to borrow up to 5 times your household income. A household income of $140,000 would therefore be able to borrow a maximum of $700,000.

The other way is calculated using the cost of servicing your mortgage against your income. So, if the Reserve Bank mandated a maximum percentage of 23%, then a household earning $140,000 would get a mortgage that costs a maximum of $32,200 per year. 

Interest rates are currently in the low 2%. So either way of calculating debt to income would result in roughly the same maximum mortgage amount for a household. As such, we don’t need to get too hung up on which way it would go. Having said that….

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How will the Reserve Bank measure these ratios?

We of course don’t know, we’re still waiting for the Reserve Bank to invite us to their strategy sessions. But it’s fun to speculate so let’s go for it!

The debt to income ratio calculation of multiplying your household income by x to determine the maximum mortgage amount: it's nice and simple and would be easy for New Zealand to understand.

The second, slightly more complicated calculation of the cost of servicing your mortgage against your income: this would be harder to communicate to consumers. But it has a big benefit to the Reserve Bank; a slight tweak to interest rates would instantly impact the maximum amount a person or household could borrow.

How can the Reserve Bank make debt to income ratios work for them?

If the Reserve Bank increased the OCR by 0.5% mortgage rates would probably go up by about the same amount. But the banks are unlikely to immediately adjust their servicing rate (currently around 6%). Those in the market to buy wouldn’t be happy about an interest rate increase. But they would likely still be keen to buy and to max out what they can borrow. 

In this situation, using the multiplication of income (eg; your income times 5) to determine the debt to income ratio wouldn’t change what someone could borrow. But if the debt to income ratio is determined by the cost of servicing the mortgage against income then suddenly a buyer with $140,000 of income can immediately only borrow $655,000 (down from $700,000). This is because we were calculating $700,000 at 2.25% but are now paying $655,000 at 2.75% (both being around $32,200 per year).  There is an immediate effect on what can be borrowed, and therefore, what can be spent on the property market.

Key takeaway is that there is no debt to income ratio implementation from the Reserve Bank in the near future, but it’s now a possibility. If implemented it would be targeted at investors. The upside is, debt to income ratios give the Reserve Bank more options before they resort to significantly hiking up the interest rates. And low-interest rates benefit all property owners, investors included.

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