Simply put a debt to income ratio is your total debts (including home loans, car loans, credit card limits etc) divided by your gross/taxable income.
Borrowers will often ask what a bank will lend them as a multiple of their income. Six times income is considered reasonable but not necessarily an accurate indication of your borrowing capacity.
And here’s why. Debt to income ratios or DTIs are used as a secondary borrowing capacity measure by Australian lenders. The primary measure is based on a household cash flow model. In essence a lender will look at all your eligible income sources – salary, bonuses, rental income and come up with a net monthly figure which might include a provision for reduced income tax via negative gearing benefits for investors.
They will then consider all the household expenses. This includes basic living expenses like food and groceries, costs of running a motor vehicle, insurances, etc. and possibly also additional expenses like private school fees or investment property running costs. Also factored in are other debts like car loans, student loans (HELP) and credit card limits.
Once all these expenses are captured and deducted from the net monthly income the remaining surplus can be used to meet new home or investment loans commitments.
Under guidance from Australia’s financial regulators the lender will stress test the new loan (and in some cases your existing loans) to take into account interest rate rises. It’s important a borrower demonstrates an ability to repay the loan at higher rates. While there are fixed home loan rates available today at less than 2%, a lender will typically stress test the loan at a rate closer to 5%.
A household with higher living expenses and debt commitments will likely be offered a lower multiple of income for their new loan than a household with low expenses and minimal or no other commitments.
The DTI measure is a blunt tool and often used as a cap rather than an accurate indication of borrowing capacity . Therefore, it’s important you discuss your borrowing capacity with your broker or lender.
Written by Chris Hill
I have been in financial services for 20 years and joined Smartmove in 2014 and enjoy working with such a passionate and dedicated team.