Rupert Gough: What Debt to Income Ratios really mean for borrowers

Recently, BNZ became the second bank in New Zealand after ASB to implement a Debt to Income ratio (DTI) policy, restricting what a mortgage applicant can borrow to a multiple of their income. At the time of writing, these multiples range from 6x income to 7x income.

For anyone in the market for a new mortgage, it’s important to understand that this policy doesn’t stand on its own and is quite heavily intertwined with another measure that the banks use - Uncommitted Monthly Income (UMI). That is to say that someone earning $40,000 can’t simply borrow $280,000 (at a 7x debt-to-income multiple) and there’s good reason for this. Day-to-day living has a minimum cost - food, utilities, repairs, maintenance and clothing as well as discretionary expenses like entertainment.

Banks have a rough minimum that they expect one or two people to be able to survive on (and a lot of people survive on significantly less but these are the bank’s rules that they use). It ranges from bank to bank but for one person you could think of it roughly as $20,000 a year and for a couple it is around $25,000. This amount varies depending on how many of the three “C”s you have: cars, credit cards and children. This estimate is your “committed income” - you need this amount to survive - what’s left over is uncommitted income.

In theory, every dollar you earn (after tax) above your committed income could be put towards a mortgage, although this doesn’t happen. It’s rare to find a household earning $300,000 that is living on $25,000 and putting the rest towards their mortgage. Typically, expenses increase as income increases.

But let’s assume it’s a perfect world; you do keep expenses low and put your leftover money towards your mortgage. How much could that have bought you and how much has this changed with the new debt to income ratios?

Many applicants will know that the banks measure your mortgage affordability (referred to as mortgage servicing capability) at a much higher rate than the current mortgage rates. Even though rates currently sit at around 3.5%, banks want to know you can afford a rate of around 6.5%, which allows for interest rates to increase in the future. Once you factor principal payments (the payments that reduce your mortgage) into account, you need to be able to afford about 9% of your mortgage. In other words, an additional $9,000 of tax-paid income could have allowed you to borrow an additional $100,000 of mortgage - until Debt to Income ratios came along.

Now $9,000 allows for an additional $54,000 of borrowing at 6x DTI and $63,000 at 7x DTI. That’s significantly down from $100,000!

You can see that UMI tends to limit the amount that lower earners can buy because everyone needs to cover their basic living costs and DTIs tend to limit the higher earners because your income doesn’t stretch as far. This is the reasoning behind Debt to Income ratios - limit how much people can borrow, which should, in theory at least, limit how much people can spend particularly when it comes to investment properties, which require significant mortgages with minor (3%-5%) returns.

Expect the remaining two main banks to implement debt-to-income ratios in the next couple of months with the ratio range most likely sticking to the 6-7x income. If you are comparing banks, it is worth asking them what is included in the “debt” part of the ratio. Typically credit cards and other loans are included (reducing the amount of mortgage you can get). The banks are yet to clarify whether student loans are included in the total debt which may be a point of difference for some banks.

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