This article will explore what DTI ratios are, how they impact your borrowing power, and what came into force 1 July 2024 as well as frequently asked questions we think will help you plan your next home loan or investment property purchase.

What is a Debt-to-Income Ratio?

The debt-to-income (DTI) ratio describes the ratio of your total debt relative to your total gross income. The DTI ratio is a financial metric used by lenders to assess your ability to manage monthly debt payments and repay borrowed money. This ratio provides lenders with a clear picture of your financial health and your capacity to take on additional debt without compromising your financial stability.

To calculate your DTI ratio, you divide your total monthly debts (such as car loans, credit card payments, and potential mortgage payments) by your monthly gross income and multiply by 100 to get a percentage. A lower DTI ratio indicates a more manageable level of debt relative to income, which generally makes you a more attractive borrower to lenders. Conversely, a higher DTI ratio suggests that a significant portion of your income is already committed to debt payments, leaving you with less financial flexibility and potentially making lenders more cautious about extending credit to you.

Example:

If you earn $5,000 a month and have monthly debt commitments totalling $1,750, your DTI ratio would be 35%.

Formula:  

New Zealand’s Confirmed DTI Ratio Regulations

New Zealand has confirmed new DTI ratio regulations aimed at stabilising property prices and aligning them more closely with wages. These regulations will cap the amount you can borrow based on your income. By setting these limits, the government aims to promote financial stability and prevent excessive borrowing that could lead to financial crises.

Confirmed DTI Caps:

• Residential Properties: Borrowing up to 6 times your annual income. For example, if you earn $100,000 a year, you could be limited to borrowing up to $600,000 inclusive of all debts for a residential property.
• Investment Properties: Borrowing up to 7 times your annual income, including rental income. This means that if your annual income is $100,000, you could borrow up to $700,000 for an investment property, considering both your salary and rental income.

These new caps are designed to ensure that borrowers do not take on more debt than they can reasonably manage, thus reducing the risk of defaults and promoting long-term financial health.

Why Debt to Income Ratios Matter

A lower DTI ratio indicates that you have a more manageable level of debt relative to your income, making you a less risky borrower in the eyes of lenders. When lenders assess loan applications, they use the DTI ratio to evaluate your financial stability and your ability to repay the loan. A high DTI ratio can signal to lenders that you might struggle to meet your debt obligations, especially if you face unexpected financial challenges such as a loss of income or an increase in interest rates.

Conversely, a lower DTI ratio suggests that you have sufficient income to cover your debt payments comfortably, making you a more attractive candidate for a loan. This can lead to better loan terms, such as lower interest rates and higher borrowing limits. Therefore, maintaining a low DTI ratio not only increases your chances of loan approval but also enhances your overall financial health by reducing the risk of overextending yourself financially.

Why Have Debt to Income Ratio Restrictions been Implemented 

The rules come from concerns about rising property prices and growing household debt. They also come from the risks of too much borrowing for individuals and households. The restrictions will aim to keep house prices in check. They will do this by limiting debt-to-income ratios. House prices experience annual increases of 7-8%. This is nearly double the 4.35% average growth of household income each year. The DTI rules aim to tie house prices more closely to income soon. They aim to ensure that homeowners and prospective homeowners do not borrow too much. They should be able to pay their mortgage and other debts.

Ideal Debt-to-Income Ratios for Mortgages

Lenders use DTI ratios to determine the risk associated with offering you credit. Maintaining a low DTI ratio can help you secure better borrowing terms and increase your chances of loan approval. A lower DTI ratio indicates that you have more disposable income available to cover your living expenses and any unexpected financial challenges that may arise.

Ideal DTI Ratios:

• Healthy DTI: 35% or less, indicating a manageable debt load. This level suggests that your debt is well within your ability to pay off comfortably.
• Cautionary DTI: 36% to 49%, which could be problematic for some lenders. While you might still qualify for a loan, you may face higher interest rates or stricter loan conditions.
• High DTI: 50% or more, which could limit your borrowing options. At this level, lenders may see you as a high-risk borrower, and you may need to take steps to reduce your debt before applying for a loan.

What Are the Impact of Debt-to-Income Ratios for First-Home Buyers

The new DTI ratio restrictions could make it more challenging for first-home buyers to secure mortgages, particularly in major cities like Auckland and Wellington where property prices are high relative to incomes. These regulations aim to prevent first-home buyers from overextending themselves financially, which could lead to difficulties in meeting mortgage payments, especially if interest rates rise or their financial situation changes.

First-home buyers may need to save larger deposits or look for more affordable properties to stay within the new borrowing limits. This could potentially slow down the housing market as demand for high-priced properties decreases. However, these changes also encourage prudent financial planning and help first-home buyers avoid the risk of financial strain associated with high levels of debt.

If you want to buy a house in a pricy region, such as Auckland, you’d need an average household income of $172,000 to buy an average-priced house. For the average New Zealand family, this is too much. Their gross income is around $115,000. This is one of the main concerns voiced to the Reserve Bank about the proposed restrictions. Tougher lending rules may require bigger down payments (deposit). They may also force buyers to settle for cheaper properties. This could worsen affordability in already hot housing markets. 

First Home Buyer Example:

The median house price in Auckland (May 2024) is $1,048,000. The DTI ratio for a first home buyer with 20% deposit ($209,600) and $838,400 mortgage on a 6.85% interest rate would be 57%:

Impact of DTIs on Property Investors

Property investors are likely to be significantly affected by the DTI restrictions. Limiting borrowing to 7 times the annual income, including rental income, could slow down property investment and impact the rental market. Investors may find it harder to finance multiple properties, which could reduce the number of rental properties available and potentially drive up rental prices.

Additionally, the new regulations could shift the focus of property investors towards properties that generate higher rental income relative to their purchase price. This shift could lead to more strategic investments and a more balanced property market, where rental yields become a more critical factor in investment decisions.

Changes to Loan-to-Value (LVR) Restrictions

The new DTI restrictions are not all doom and gloom. The Reserve Bank has eased limits on loan-to-value ratios (LVRs). The new bank rules state that no more than 5% of their housing loans to investors can go to borrowers with less than 30%. A decrease in the deposit investors require, from 35% currently required to invest. For homeowners, the Reserve Bank plans to cap the size of loans to borrowers with deposits less than 20% at 20% of the bank’s total lending. This raises the cap by 5%. It gives more flexibility for some New Zealanders to secure approved home loans.  

Economic Implications for New Zealand’s Economy

A slowdown in the housing market due to the DTI restrictions could have broader economic implications. The construction and real estate sectors are significant contributors to the New Zealand economy, and reduced borrowing capacity could lead to a slowdown in these sectors. This slowdown might result in fewer new housing projects, affecting employment in construction and related industries.

Moreover, a more stable housing market could lead to more sustainable economic growth in the long term. By preventing excessive borrowing and reducing the risk of defaults, the new DTI regulations could contribute to a healthier financial system. This stability is crucial for maintaining consumer confidence and ensuring that the economy can weather future financial shocks. Reduced volatility in the housing market can also lead to more predictable and steady growth, which benefits both homeowners and investors alike.

On the other hand, a more regulated borrowing environment might encourage potential homeowners and investors to explore other avenues for building wealth, such as investing in the stock market or starting new businesses. This diversification can lead to a more robust and resilient economy, less dependent on the property market alone. Overall, while the immediate impact may include slower growth in property-related sectors, the long-term benefits of financial stability and sustainable growth could outweigh these short-term challenges.

Managing Your DTI Ratio

To improve your DTI ratio, consider the following strategies:

• Pay Down Existing Debt: Reducing your overall debt load can lower your DTI ratio. Focus on paying off high-interest debts first, such as credit card balances, to make the most significant impact.
• Increase Your Income: Boosting your income through additional work, side jobs, or investments can help improve your ratio. Consider taking up freelance work or exploring investment opportunities that provide passive income.
• Refinance High-Interest Debt: Consolidating high-interest debt into a lower-interest loan can reduce your monthly debt obligations. This step can free up more of your income for other expenses and savings.

Monitor Your Financial Situation: Regularly review your DTI ratio to ensure you remain within manageable limits. Use budgeting tools and financial apps to track your income and expenses accurately.

DTIs Frequently Asked Questions

1. What is a good DTI ratio for a mortgage? A lower DTI ratio is generally better. Banks in New Zealand may not approve a mortgage if your DTI ratio exceeds six times your income. A ratio below five times is beneficial, with three to four times being preferred. Keeping your DTI ratio low indicates to lenders that you have a healthy balance between your income and debt, reducing the risk of default.
2. Can I get a mortgage if my DTI ratio is high? It is possible, but more difficult. Lenders may approve a mortgage with a high DTI ratio if you have a strong credit score or other favourable factors. However, you might face higher interest rates or stricter loan terms. Improving your DTI ratio is advisable to increase your chances of approval and secure better loan conditions.
3. Do DTI ratios include only mortgage payments? No, DTI ratios include all debt payments, such as credit card balances, car loans, student loans, and other obligations. All debt payments must be included when calculating your DTI ratio. This comprehensive view helps lenders accurately assess your financial health and your ability to manage additional debt.
4. Can DTI ratios be improved after a mortgage is approved? Yes, you can improve your DTI ratio by paying down debt, increasing your income, refinancing your debt, or reducing monthly expenses. Improving your DTI ratio after securing a mortgage can help you better manage your financial obligations and reduce the risk of defaulting on your loan.
5. Is there a universal maximum DTI ratio for mortgages in New Zealand? No, the maximum DTI ratio varies by lender and mortgage type. Some lenders have stricter ratios, while others may be more lenient. It’s essential to shop around and compare different lenders to find the best terms for your financial situation.
6. How do DTI ratios compare to other financial ratios? DTI ratios measure debt relative to income, while other ratios like debt-to-asset or debt-to-equity compare debt to assets or equity. Lenders use DTI ratios to assess borrowing risk, as they provide a direct indication of your ability to manage monthly debt payments.
7. Can DTI ratios be affected by mortgage rate type? Yes, variable rate mortgages may have lower DTI caps due to fluctuating interest rates, while fixed-rate mortgages with consistent rates might allow higher DTI ratios. Understanding how different mortgage types impact your DTI ratio can help you choose the best option for your financial situation.
8. What happens if my DTI ratio is too high? A high DTI ratio can make it harder to get a mortgage. You may need to reduce your debt or increase your income to improve your ratio. Lenders may also offer alternative financing options, but these might come with higher interest rates or less favourable terms.
9. How can I plan for DTI volatility? Build an emergency fund, manage debt wisely, consider mortgage insurance, and monitor your DTI ratio regularly to plan for potential changes. Staying proactive about your financial health can help you navigate fluctuations in your DTI ratio and maintain stability.
10. Do DTI ratios apply to first-home buyers? Yes, first-home buyers need to understand and manage their DTI ratios to increase their chances of mortgage approval. Staying within recommended DTI limits can help first-home buyers secure better loan terms and avoid financial strain.
11. How do DTI ratios relate to negative equity? Negative equity occurs when property value is less than the mortgage debt. High DTI ratios combined with negative equity can make refinancing difficult. Maintaining a low DTI ratio and keeping a close eye on property values can help you avoid this situation.
12. If my household income drops, will DTI ratios limit my ability to remortgage? Yes, a drop in income can increase your DTI ratio, making remortgaging more challenging. Planning for potential income changes and maintaining a low DTI ratio can help you stay prepared for such situations.
13. Which mortgage applicants are tested on DTI ratios? DTI ratios apply to all individuals and households seeking a mortgage or refinancing their existing mortgage. Understanding your DTI ratio and how it affects your borrowing power is essential for all mortgage applicants.

Conclusion

Understanding and managing your DTI ratio is crucial for maintaining financial stability and securing favourable borrowing terms. With the recently implemented changes to DTI ratio regulations in New Zealand, it’s more important than ever to stay informed and take proactive steps to manage your debt and income effectively. At Meta Financial Solutions, we’re here to help you navigate these changes and achieve your financial goals.