There has been talk this week about debt-to-income ratios due to the Reserve Bank asking the Government to consider it as part of its macro-prudential toolkit.
At its simplest, a DTI rule would be that a borrower cannot borrow more than five times their gross annual income. The UK has applied a DTI rule for owner-occupied houses of 4.5 since June 2014. Debt includes mortgages and any other debts like personal loans, credit cards etc.
For the majority of our clients any rule around DTIs would have no impact. A Reserve Bank survey of our major banks last year showed that 74% of first home buyers are below a DTI of five and 63% of other owner-occupied. Arguably a DTI approach may allow the Reserve Bank to slightly loosen LVR (loan-to-value) restrictions for first home buyers, alleviating deposit requirements.
DTI by Income (Source RBNZ November Stability Report)
DTI by Borrower Type (Source RBNZ)
The tricky situation that doesn’t fit nicely inside the DTI box is maternity leave. If I have a client with one of the borrowers on maternity leave, they may be prepared to run a high DTI initially over the first 2-3 years. This is a very common scenario in Auckland where two incomes are often required for servicing and new parents are older. In these situations, a higher DTI might be reasonable but would sit squarely outside the rules as an unintended consequence.
Banks already apply servicing calculations to test a borrower’s ability to service their lending. These calculations use a mortgage rate of around 6.50% (compared to an actual rate of around 4.30%) and assume P&I over a 30-year term. Then there is the Responsible Lending Code which requires lenders to properly account for living costs. Between these, banks are already properly assessing affordability for first home buyers and applying a degree of conservatism.
It could be argued that the DTI is therefore a blunt instrument that is not about being prudential, It is either (1) nanny state – protecting people against themselves, or (2) the RBNZ doing the Government’s job for it in an effort to control house inflation. The Reserve Bank has had to step well outside of its traditional mandate lately to counterbalance a Government that in my opinion is too laissez-faire.
Where DTIs would work, is if applied to investors. Roughly 60% of Investors have a DTI over five. This is to be expected as investors can generally divert more income to servicing and therefore carry higher leverage. A retired investor could have a portfolio of $3m of investment property with $1m of debt and at a yield of 4% they’ have a DTI of eight.
My own experience is that high DTIs will be prevalent in the Asian market with there is significant equity but lower taxable incomes, and investors near or in retirement. Banks refer to these types of clients as “rent reliant.” It’s also a space where spruikers work encouraging middle NZ to leverage up to their eye-balls on property.
For investors a DTI is again a blunt instrument and I wonder to what extent it works better than the servicing tests already applied by banks. Banks use a mortgage rate of roughly 6.50% on a P&I basis and only include 75% of rents to allow for property expenses.
Bear in mind that the Reserve Bank has already removed the ability to use foreign based income for servicing (which was a smart move), and it has tightened up AML requirements making it near impossible for foreign nationals to borrow money in NZ. Both changes positively impacted on the issue of cheap foreign capital pouring into our property market, which has always been my main bugbear and was ignored for years.
Rather than pulling out the bazooka of DTIs I’d like to see the RBNZ use a rifle and continue to finesse the rules already applied.
As a starter for ten – property investors should not be able to include boarder income or rental income from their owner-occupied property for servicing. You’d be surprised how common this is. It’s these sorts of subtle rule changes that hit the parts of the market that are genuinely highly geared whilst not having unintended consequences elsewhere.
The banks have already demonstrated that they are on-board with this approach having rigorously applied the RBNZ direction throughout the year.
As I’ve noted in previous posts I think the Reserve Bank has already applied sufficient force to the property market, and this is still playing out. There is an increasing risk if they get their meddling wrong, it could create a liquidity trap. For some business owners caught out by the last set of changes, it already is.
From here I’d like to see more finesse and less sledge hammer, so we can avoid more unintended consequences.
John Bolton is the "Chief Squirrel" and CEO at Squirrel Financial Services. This article was first posted on the Squirrel Mortgages blog, and is here with permission.