Debt to income ratios: What are they and what effect will they have on house-buying?

COMMENT: In the last couple of months, a number of drastic monetary policy changes have been introduced, the latest being that the Government has given the Reserve Bank the power to use debt to income (DTI) ratios. This adds another lever for the Reserve Bank to use in an effort to keep the property market under control.

DTI ratios can be measured in two ways. The most simple is a division of your income against the overall mortgage and this is largely how most Kiwis have assumed it will be employed. The Reserve Bank could, for example, mandate a maximum DTI ratio of five, meaning you would only be able to borrow a maximum of five times your household income. A household income of $100,000 would therefore only be able to borrow at the most $500,000.

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You can, however, also calculate DTI ratios as the cost of the debt against your income. In this instance, if the Reserve Bank mandated a maximum percentage of 23%, then a household earning $100,000 couldn’t raise a mortgage that cost them more than $23,000 per year. A $500,000 mortgage over 30 years at 2.19% is $22,752 so a debt to income ratio of five times income and 23% (in the current world) has roughly the same effect.

Although the first option is easier for consumers to grasp (multiply your income by x for your maximum borrowing) you may find the Reserve Bank favours the second option because a small tweak to interest rates will have an immediate effect on the consumers' ability to get finance.

Suppose the Reserve Bank increases the official cash rate (OCR) by just 0.5%. In our current world, mortgage rates would probably go up by the same amount but it’s unlikely the banks would quickly adjust their servicing rate (which currently sits around 6%). People would grumble about the interest rate being now in the high twos but would unlikely adjust their enthusiasm for property quickly. Those who could buy before the OCR rise would still be able to buy and probably still would. An interest rate of less than 3% is still good after all.

But with a DTI ratio of 23%, a purchaser with $100,000 of income can immediately only purchase $470,000, which doesn’t sound much different to $500,000 but is enough to be significant especially as the numbers get larger. The difference between a $1 million house and a $940,000 house in Auckland can be a whole bedroom. The outcome is an immediate effect of any change to the OCR on the property buyers' ability to borrow.

While this new lever may seem like bad news for first home buyers, the Reserve Bank and the Government will likely be working to make sure it has minimal impact on first home buyers from their current ability to borrow. Investors may, on the other hand, find they need to top up even more money once this rule is combined with the new rules around interest expense deductibility.

But current home owners should take a bit of solace from the introduction of more financial restraints. The more of these, the less the Reserve Bank will need to resort to significant interest rate hikes. This means interest rates will stay lower, longer and savvy homeowners can continue to pay down their mortgage in the meantime.

Disclaimer: this article is meant as an explanation of DTI ratios and not as a forecast of how they will be implemented.

- Rupert Gough is the founder and CEO of Mortgage Lab and author of The Successful First Home Buyer.