Debt-to-income (DTI) ratios are a measure of how much debt a borrower has compared to their income. DTI ratios are used by banks and regulators to assess the risk of lending to borrowers, especially for residential mortgages. They are calculated by dividing the total debt of a borrower by their gross annual income.
In New Zealand, there is no official limit on DTI ratios for mortgage lending, but the Reserve Bank of New Zealand (RBNZ) has signalled to the main banks to prepare their systems for DTI implementation as they may introduce restrictions in 2024. The RBNZ has stated that high DTI ratios pose a risk to financial stability, as they make borrowers more vulnerable to income shocks, interest rate increases, or house price declines. The latter two are being felt widely right now.
What DTI’s can achieve though is a stabilisation of house prices overtime. Consider this; if a borrower wants to buy a house for $800,000 but they are only able to afford $700,000 with a mortgage and deposit, and enough people are in the same position, then the price of that house becomes $700,000. Now, you might argue that someone else might have $800,000 to buy it, but house prices aren’t denoted by what a seller wants or what just one buyer has, they are denoted by what the market as a whole can afford to pay. If the market is restricted on borrowing, then house prices are restricted.
This can mean that house prices grow more slowly than they have in the past and this has the ability to reduce the spikes in house prices we’ve experienced in the past few years. So they could be a positive tool that saves us from ourselves. However, that might not be what an individual wants to hear.
If the RBNZ were to introduce DTI restrictions, it could have a significant impact on investment property buyers in New Zealand. Depending on the level and design of the restrictions, investors may find it harder or more expensive to access mortgage finance, or may have to reduce their borrowing or sell some of their properties.
To illustrate this point, let’s consider an example of an investor who has one rental property and wants to buy a second one. The investor has a gross annual income of $100,000 from their main job and $30,000 from rental income. Their total debt is $700,000 consisting of a mortgage of $300,000 on their own house, and $400,000 on the rental property (assuming this had been purchased a few years ago). Their current DTI ratio is 5.4 ($700,000 / $130,000).
The investor wants to buy a second rental property worth $600,000 earning rental income of $40,000 (6.7% return) and they plan to borrow the full amount by using equity in their existing properties. This would increase their total debt to $1.3 million and their income to $170,000. Their DTI ratio is now 7.6 ($1.3 million / $170,000).
If the RBNZ were to impose a DTI limit of 6 for investors, this investor would not be able to get a mortgage for the second rental property under these terms. They would have to either increase their income, reduce their debt, or lower their purchase price.
This effectively stops them from purchasing additional properties, and this example is significant as round 78% of investors in New Zealand only own one rental property. Due to the volume of potential buyers they represent, they are more likely to be the group looking for a rental property purchase to increase their portfolio, but will effectively be stopped from doing so.
If this investor in our example did have cash to put into the deposit and borrow less, they may have the ability to purchase the next property, but not the third property. If a property generates income to the example above, then its own DTI ratio is around 15, and eventually, an investor can’t buy more property.
However, the point isn’t about the individual’s circumstance, it’s about the market as a whole. If you have less investors able to borrow for an investment property, you have a lack of demand. A lack of demand slows the capital growth of the investment asset as there are less people to purchase what the market potentially has to sell. It may even reduce the prices, although other factors like interest rates and interest deductibility have already dealt with that.
Now consider all the investors out there that are currently higher than a potential DTI limit that RBNZ might set, due to their existing borrowings and income in place. This may prevent them from borrowing against their own house to complete a personal renovation for example, or to borrow to invest funds into a business. The banks look for security against these types of loans and your property could already be maxed out. The implications of the DTI ratio’s may have unintended consequences down the line.
Some possible effects of DTI restrictions on investment property buyers are that this reduces the demand for investments, and therefore reduces the supply of rental housing making it harder for tenants to find affordable and suitable accommodation. It could reduce the tax revenue overall for the government and have off-shoot issues for less economic activity in the areas around investment property that service the sector.
These effects are not certain or inevitable, as they depend on various factors and assumptions, such as the level and design of the DTI restrictions, the behaviour and preferences of investors, the availability and cost of alternative sources of finance, and the responses of the RBNZ, the government, and the market.
However, they illustrate some of the potential implications that DTI restrictions could have for investment property buyers and the wider economy. Therefore, it is important for the RBNZ to carefully weigh the costs and benefits of introducing such restrictions, and we’ll all have to wait to see what they do in 2024.
The statements made within this article are in the opinion of the individual writer only and do not constitute legal or specialist financial advice. Please seek independent legal advice when dealing with all property transactions.
Matt Morton is a specialist residential investment broker (since 2011).