How Will The New Debt To Income Ratios Work?
What is Debt To Income Ration (DTI)?
We’re about to get very familiar with a new acronym in lending – DTI’s. Those jumble of letters represent the debt-to-income ratio Banks will use when assessing a borrowers application for finance.
This creature is the new macro prudential tool of the Reserve Bank. The Central Bank has long argued for its introduction, since pre-2013. Our Government finally granted permission to implement the ratio on the basis its application will act as a restraint on the next housing price cycle and will assist the Reserve Bank in promoting long-run stability in our monetary and financial system.
Personally, I wonder if the shiny new tool is necessary. After all, our banks have long proven they can well monitor their own lending practices. It also seems disingenuous for the Central Bank to be telling the registered banks how to conduct their lending practices.
We all know the pain we’re currently contending with has been caused by the Reserve Bank lowering the OCR to unprecedented depths, causing credit to literally be thrown at people and then doing an abrupt about-turn, increasing the OCR and ensuring bank lending rates follow.
The above aside, DTI’s are coming. Their official application date is yet to be revealed. The Reserve Bank has announced however it will loosen current LVR rules on 1 June 2024 so perhaps DTI’s will be introduced on this date.
How Will The Debt To Income Ratio Work?
Given a Bank looks at many factors when assessing a borrower’s application for mortgage finance such as those falling under the headings of character and capacity, is the imposition of DTI’s such a big event?
Possibly not for a homeowner on the basis that lending to owner-occupiers will be exempt from their application. If however, that is not the case, the ladder to borrowing money to purchase a humble abode could have risen a few rungs higher depending upon the ratio limit.
Consider this …
You earn $95,000 per annum. You want to buy a home. At the time of making your loan application, a DTI of 7 exists. That means you won’t be able to borrow more than a total of $665,000. With prices what they are in Auckland, that’s going to make buying pretty difficult. Surely we need to make it easier for first-home buyers to purchase. Homeownership is a very beneficial thing, both personally and to the community. Imposing DTI’s on homeowners seems to me to penalise those who want to put down roots and gain some stability in their lives.
Those who team up with a nearest and dearest are likely to have larger incomes but won’t necessarily fare better. Let’s assume a couple have a combined income of $140,000. Theoretically, they could borrow up to $980,000 if DTI’s were set at 7. That should go some way to buying a family home. But remember … all debt is considered so student debt, personal debt, credit card debt, etc will be taken into account when this ratio is applied.
Thus, if all debt including the desired mortgage borrowings is more than $980,000 in total, our couples application for a mortgage could be declined.
Investors could be particularly hard hit by this new lending ratio. Yes, their personal income, existing rental income and what they’ll receive on the proposed rental property purchase will be considered when they submit their application of additional lending, but would that be enough to satisfy the applicable DTI ratio? Loosening the existing LVR restrictions may help but applying a DTI ratio could well cancel out that slim advantage. As such, I think the imposition of DTI’s could severely curtail an investor’s ability to increase their portfolio.
The Reserve Bank agree with this sentiment. Their modelling showed an investor with a relatively large portfolio of 7 to 10 properties might not be able to purchase another home for 10 or more years once DTI’s had been imposed. Even those investors with 1 or 2 properties may have to wait for 5 or more years to add to their portfolio giving time, waiting for incomes to grow to service greater debt levels.
This all adds up to investors considering bringing forward their buying decisions. Alternatively, maybe investors will look to procure their funding from non-bank lenders as this type of lender won’t be mandated by the Reserve Bank to apply DTI’s. Yet another reason for the recent popularity rise in non-bank lenders.
Questions Left Unanswered
I along with the rest of NZ have many questions when it comes to DTI’s. What will the magical number be? 7 or 11 or something in between? How will the number be determined? Will the ratio move up and down, like LVR’s have? Will any property such as a personal home be exempt from their applications? Will the ratio apply to all borrowers or only to investors for that matter? Will there be only one ratio applicable to all borrowers and /or all types of property or will differing ratios be imposed such as they do overseas? Most importantly, what effect will DTI’s have on property prices? That is a particularly important question as it’s long been New Zealander’s practice to buy property to fund their retirement, either selling a property or two to clear debt and put funds in the bank to live on or as supplementary (rental) income to New Zealand superannuation received.
Will Debt To Income Ratios Actually Work?
The Reserve Bank argues it needs both LVR and DTI tools to carry out its mandate of ensuring financial stability in our system. LVR’s compare the loan to be given to the value of the property in question. In other words, LVR’s concentrate on a property’s value whereas DTIs concentrate on a borrower’s income, comparing an individual’s total debt position to the quantum of their income. One tool is focused on improving the resilience of the financial system through reducing potential losses when borrowers default on their mortgages whereas the other, is aimed at reducing the probability of a systemic wave of borrowers defaulting. Both go hand in hand, fulfilling a different function but aimed at the same objective of ensuring our financial system remains stable.
Whilst only time will reveal if these tools do work in the manner they are intended, what seems crystal is house prices will become more closely tied to incomes over time through the imposition of DTI’s. Ultimately, this means DTIs will limit the number of properties a person can own, until such time as their income is sufficient to satisfy the ratio, whatever that magical number is at the time of borrowing. Overall, capital growth will be linked to long-term income growth. If this means the market will slow down, permitting one and all to achieve the Kiwi dream of owning a home of their own, then I’m all for that.
Janet Xuccoa
Trust Advisor
BCom – LLB
JanetXuccoa.com
BWTS.co.nz