New Debt-To-Income Ratios

What you need to Know

The Reserve Bank will introduce debt-to-income ratios from 1 July 2024.

I previously discussed this in my January 2024 newsletter, but now that the Reserve Bank has confirmed what their regulations will look like, it’s timely to explore DTIs in greater detail!

What Is A Debt-To-Income Ratio?

DTIs are a ratio used to assess the ability of borrowers to manage their debt repayments in relation to their income. It’s calculated using the following formula:

Total Debt ÷ Gross Income = DTI Ratio​

That formula includes the following components:

• Total Debt: An individual’s total debt includes all their outstanding debts, such as mortgages, personal loans, car loans, student loan and credit card debt.

• Gross Income: This refers to the borrower's total pre-tax income from all sources.

• DTI Ratio: The score that is assigned to an individual to demonstrate their borrowing power.

For example, if a borrower has total debts amounting to $600,000 and a gross annual income of $100,000, their DTI ratio would be 65 (or 600%).

Note, if there is more than one borrower then their income and debts will be combined to calculate the DTI.

Why Is A DTI Important?

The Reserve Bank believes that the debt-to-income ratio is a good indication of what a person is financially capable of borrowing. They feel it is a critical measure to help banks, financial institutions and other lenders determine the risk associated with lending.

Having a low debt-to-income ratio indicates that you are a relatively safe lending option as you should be able to maintain debt repayments in your current circumstances. However, having a high debt-to-income ratio could indicate that you are over-leveraged and may struggle to meet your repayment obligations if your income were to decrease or interest rates were to rise.

By setting limits on debt-to-income ratios, the Reserve Bank is aiming to curb risky lending practices. If they limit high DTI lending, then it is less likely borrowers will take on excessive debt, reducing the risk of defaulting during economic downturns. They also want to ensure house prices don’t blow out as high levels of mortgage debt can drive up house prices, creating bubbles in the property market.

What Does It Mean?

A bank will be limited to lending a maximum of up to six times an individual’s gross income  for an owner-occupied property and seven times for an investor.

There are some limited exceptions, banks on a case-by-case basis are able to lend 20% of their total lending to an owner occupier with a DTI exceeding six and to an investor with a DTI exceeding seven.

I would expect that banks will be very cautious when approving any exceptions to the DTI rules.

Want will the impact of DTI be?

In the current market, these changes are unlikely to have much impact as high interest rates are preventing people from getting large mortgages. But, when mortgage rates go down, DTI will come into play. Some application that previously would have been approved with DTI’s will now be declined.

The burden of DTI will fall unevenly on those with higher incomes who have a greater ability to service a larger mortgage. Pre-DTI’s they had the ability to borrow more than six times their incomes but will now be restricted in the amount they can borrow. If DTI were in place over that last 2 to 3 years some applications that were approved would have been declined.

The biggest impact would be if house prices were to increase significantly compared to household incomes or if interest rates were to rapidly fall.

We still find ourselves in uncertain times. While the introduction of DTIs might not have much impact in the short term, it doesn’t change the fact that no one is certain of what lies just around the corner!

We still don’t know when mortgage rates will go down and there was even talk, be it short lived that the OCR  might increase later in the year. The latest forecasts don’t have the interest rates falling until mid-2025.