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Understanding the Changes to Debt to Income Ratios

A debt to income (DTI) ratio is a metric used by lenders to assess a borrower’s ability to manage monthly debt payments and repay a mortgage. It is commonly used in many overseas markets, but it a new metric in New Zealand.

The DTI is calculated by dividing the total monthly debt payments by the borrower’s gross monthly income. For example, if your total monthly debts were $100,000 and your income was $100,000, your DTI ratio would be 1. This ratio helps lenders determine the risk level of lending money to a borrower; the lower the DTI ratio, the less risky the borrower is perceived to be.

The importance of the DTI ratio for owner occupiers cannot be overstated. It directly affects one’s ability to secure a mortgage and influences the terms of the loan, including the interest rate and the size of the mortgage for which one can qualify. A lower DTI ratio typically indicates better financial health and a higher capacity to manage additional debt, which can result in more favourable loan terms.

Recent Changes by the Reserve Bank of New Zealand

In an effort to maintain financial stability and ensure prudent lending practices, the Reserve Bank of New Zealand (RBNZ) will be implementing new restrictions on DTI ratios. These restrictions will come into force on July 01, 2024 and will require banks to adhere to specific lending limits based on borrowers’ DTI ratios.

Previously, there were no formal DTI restrictions imposed by the RBNZ, allowing banks to set their own thresholds. This often led to higher DTI ratios being approved, particularly in a competitive lending environment. However, the new rules now stipulate that banks are generally prohibited from lending to owner-occupiers with a DTI ratio greater than 6, and to property investors with a DTI ratio greater than 7.

This means that if your total debt payments exceed six times your gross annual income for owner-occupiers or seven times for property investors, obtaining a mortgage will be significantly more challenging. In monetary terms, applying this ratio would mean that as an owner occupier if you earned $100,000 p/a then the maximum amount the bank would lend you would be $600,0000.

Banks have been given a 12-month transition period to fully comply with these restrictions.

Impact on Owner Occupiers

Currently, while interest rates remain high, banks apply a stress-test to most owner-occupier applications to see if the property owners would still be able to afford their repayments if interest rates rose to 9%.  This means that while interest rates are high, the changes to the DTI are unlikely to have much impact on lending. However, with an expected drop in interest rates occurring from next year, which would result in lenders stress testing loan applications at a lower rate, the RBNZ restrictions do have the potential to start impacting lending.

For current and prospective owner occupiers, the RBNZ’s changes mean a more rigorous assessment process. Those seeking to buy a home will need to ensure their DTI ratios are within the acceptable range, which may involve reducing existing debt or increasing income to improve their financial standing.

Existing owner occupiers might not be directly affected by the new DTI rules unless they seek to refinance or take out additional loans. However, those considering refinancing should be aware that their current DTI ratio will play a crucial role in the approval process and the terms they can secure.

According to the RBNZ, the tighter DTI restrictions aim to foster a more stable financial environment by ensuring borrowers do not take on excessive debt relative to their income. This could ultimately benefit owner occupiers by contributing to a more sustainable housing market, reducing the risk of defaults, and promoting long-term financial health.

Putting your best foot forward

For owner-occupiers looking to secure new lending or to re-finance existing lending, it is possible to improve your DTI by taking actions such as: 

  • Reduce Existing Debt: Pay down credit card balances, personal loans, and other debts to improve your DTI ratio.
  • Increase Income: Consider ways to increase your gross monthly income, such as taking on additional work, seeking higher-paying employment, or taking in flatmates / boarders.
  • Budget Wisely: Create a strict budget to manage expenses and avoid taking on new debt.
  • Refinance Existing Loans: While not necessarily helping directly with improving your DTI, as interest rates drop it may be beneficial to refinance existing high-interest loans to lower monthly payments and helping with normal servicing.
Impact on Property Investors

Beyond owner-occupiers, the new DTI restrictions will also have notable implications for property investors. Typically, investors often leverage their existing properties to finance new acquisitions making higher DTIs more common. With the stricter DTI limits, investors may find it harder to secure additional funding, potentially slowing down their investment activities.

These changes might lead investors to re-evaluate their strategies, focusing more on paying down existing debt to lower their DTI ratios. Alternatively, investors may need to explore other financing options, such as partnerships or private lending, which might not be subject to the same stringent DTI requirements as traditional bank loans.

Moreover, property investors might see a cooling effect on the housing market, as DTI restrictions will limit the level of borrowing able to be secured. This could potentially lead to slower property value growth and a more balanced market, providing a less frenzied environment for both buyers and sellers.

For property investors looking to expand their portfolios, we recommend considering how to pay down existing debt to reduce debt levels to within the new DTI limits, and to plan for market changes and a potential cooling in the housing market and adjust your investment plans accordingly.  

    What to do now

    Understanding DTI ratios and their significance is essential for anyone navigating the mortgage landscape. The changes introduced by the RBNZ introduce stricter controls on banks’ ability to lend, with the aim of enhancing financial stability and prudent lending practices.

    In our opinion, the existing system was already conservative enough and DTI’s just add more complexity, but property owners and investors must play the hand they are dealt and the key will be to understand the impact of these changes and what action you can take to put your best foot forward. By maintaining a healthy DTI ratio, borrowers can improve their chances of obtaining the best possible mortgage rates and terms, contributing to a more secure financial future.

    For property investors, these changes might necessitate a strategic shift in when and how they grow their portfolio, while owner occupiers will need to pay closer attention to their debt levels and income to secure favourable mortgage terms. And if there is any silver lining, it may be that the application of DTI by lenders may slow down house pricing growth as people will be unable to borrow as much. 

    The content of this article should not be taken as financial advice, or a recommendation of any financial product. Threefold is not liable or responsible for any information, omissions, or errors present. We recommend seeking advice from a qualified financial adviser before taking any action.