Debt-to-income ratio 101

Applying for a home loan can take on almost mystical proportions, with most Australians unsure of just how much money they can borrow. As a result, they often make the mistake of trying to secure too much money, only to be knocked back.

Most people understand they need a deposit, usually 20 per cent or more of the purchase price, and to provide details of their income and credit history to secure a loan. Still, too often, they overlook the bank’s need to conform to certain set debt ratios.

These formulas have been developed over time to determine what is and is not a safe level of debt for an individual or couple to take on, given their income and overall outgoings, and so ensure banks don’t make the mistake of extending too much credit to someone wanting to buy their own home.

Consider Charles and Holly, for example.

They are a young couple who have been saving for a deposit for several years. They feel confident they are in a good position to secure the loan needed to help them buy the home of their dreams.

To confirm this, they need to determine their debt-to-income ratio by adding up their total monthly obligations and then dividing this by their gross monthly income.

They calculate they earn a total of $6,000 a month before tax and spend $400 on Holly’s car repayments and $1,000 on Charles’ car loan.

Their total monthly repayments of $1400 are divided by their gross income of $6000, leaving them with a debt-to-income ratio of just 23 per cent.

They could reduce this even further if they decided to get by with just one car and sell the other.

While banks all have their individual ratios, most financiers want a debt-to-income ratio of less than 36 per cent. If you are refinancing an existing mortgage, no more than 28 per cent of your total gross income is to be used to service your existing home loan.

Banks will also consider your debt-to-credit ratio.

Credit agencies compare all your credit card account balances to the total amount of credit you have available.

So, if Holly owes $4,000 on a credit card with a credit limit of $10,000, their debt-to-credit ratio is 40 per cent.

The closer you are to maxing out your credit cards, the higher the score and the harder it is to obtain new finance. Often, having received a credit-to-debt ratio score from a credit rating firm, financiers will approve a loan on the condition that you either close a credit card entirely or reduce your credit limit.

The other key ratio you should be aware of is your loan valuation ratio.

Your bank will arrange an independent valuation of the property you are hoping to buy. Then, depending on the type of property it is, the bank will impose a loan valuation ratio.

This often confuses people for two reasons. First, the independent valuation is a conservative valuation of what the bank can be confident of achieving for a property in a fire sale situation. That is if you default on the loan and the bank needs to sell the property quickly to get its money back. Often the valuation can be substantially below the purchase price.

It also excludes the costs associated with buying the property. For example, a property might sell for $900,000, but there will also be other costs, such as the solicitor’s fees for handling the change of ownership, or conveyancing and stamp duty costs.

Typically, the bank will only lend a percentage of their valuation. For example, where a property is valued at $850,000, the bank will be willing to lend $680,000. The homebuyer is then expected to provide the remaining funds needed to buy the property.

The loan valuation ratio will also vary according to the type of property. A farm or large acreage could have a loan valuation ratio as low as 50 per cent, reflecting the high risk attached to such properties.

Charles and Holly, though, are hoping to buy a small suburban house in a good location and have been told their bank will apply a loan valuation ratio of 80 per cent, reflecting the bank’s confidence that they could get a reasonable price for the property, even in a default situation.

Some financiers will lend at an even higher ratio of 95 per cent of the independent valuation if you take out mortgage insurance. While you pay for this insurance, it is actually there to protect the banks and not yourself.

Lenders’ mortgage insurance will only cover any losses incurred by the banks, should they find themselves in a situation where you default on the loan, and the bank is forced to sell the property on your behalf. Home buyers often misunderstand this and wrongly believe it is there to cover their financial interest in the property or cover the deposit they may have paid to secure the property in the first place.

Charles and Holly now look at their financial situation differently and, given their better understanding, decide to sell one car, use the proceeds to extinguish Holly’s credit card, and set themselves up to get the best home they can.