The first home buyer process
The New Zealand housing market is never far from the headlines these days thanks to fluctuating house prices and a market that has favoured sellers for some time now. Among the flurry of buying and selling lurks the ever present fear that people might be borrowing more money than they should. The concern being that if house prices were to fall too far, people would be left with home loans larger than the value of their house – this is called negative equity.
How does it compare to LVRs?
A scenario where mortgages are greater than house values places the wider New Zealand economy at risk and is one of the reasons the Reserve Bank of New Zealand introduced loan-to-value ratio restrictions several years ago. LVRs dictate limits on how banks are able to lend to customers by comparing the size of the loan to the value of the house. An LVR of 80% means your loan is 80% of the value of the house. In other words, your equity would be 20%.
How does debt to income ratio work?
Recently, the Reserve Bank has been mulling over the introduction of another tool - debt-to-income ratio. Although at this time, it looks unlikely that it will be introduced, it is a good idea to understand how DTI works, should the tool be brought in.
Debt-to-income ratio takes a slightly different view of things compared to LVRs - simply put, DTI ratio compares how much you owe each month to how much you earn before tax. Where LVRs consider the relationship between the size of the loan and the value of the house (your equity), DTI looks at your loan in relation to your income (your ability to make your debt repayments each month).
Does my existing equity matter to DTI ratios?
If you’re an existing homeowner wondering if your increasing equity (due to rising house values) will improve your DTI ratio, the answer is, not really. It’s important to realise that DTI is concerned with your income, rather than how much your house is worth. The only way to improve your DTI ratio is to earn more money and/or to reduce the size of your debt commitments.
Calculate your current debt-to-income ratio
Here’s how to work out your DTI ratio. Simply add up all your debt (use the minimum payment for loans, car loans, student loans, credit cards and so on) then compare that figure to your annual gross income (i.e. before tax is taken out).
Here’s a simplified example to help you figure yours out:
Say your total debt for the month was $20,000 and your gross income is $60,000. This would mean your DTI ratio is 33% (20,000 is 33% of 60,000). For a lender, the lower the percentage, the less risky you are.
On safe lending
Banks make money from customers successfully paying off their loans, so it’s in their interest to lend safely to people. To do this, they use a number of calculations and thresholds to determine your ability to make ends meet when saying yes or no to a home loan application. You can get a good idea of how they do this by using an online home loan calculator. Banks also have a range of different home loans designed to cater to people’s individual borrowing needs.
As of Nov 2017, debt-to-income ratios aren’t being used in New Zealand to control house prices, but if you’d like to keep abreast of developments as they happen, keep an eye on BNZ Chief Economist, Tony Alexander’s regular commentary.