Box C: Debt-to-income ratios of New Zealand borrowers
This page contains information on the debt-to-income ratios of New Zealand borrowers from the November 2015 Financial Stability Report.
Around 40 percent of residential mortgages in New Zealand are issued at more than five times the borrower’s gross income. Total debt-to-income multiples (TDTIs) have increased substantially since the 1980s, when banks were usually unwilling to lend customers more than two times gross income.1 This box discusses risks around elevated TDTIs, and policies related to mortgage servicing in New Zealand and abroad.
Sustained declines in interest rates since the 1980s have been a significant factor enabling borrowers to service larger loans relative to income. Lower inflation rates have also meant that mortgage repayments remain a significant burden for much longer (high inflation means nominal incomes rise faster, so mortgage repayments diminish quickly relative to incomes). On the supply side of the credit market, New Zealand banks have generally found mortgage lending profitable. As a result, banks have competed to grow market share, partly on the basis of the amount they have been willing to lend to individual borrowers.
For the majority of borrowers with sufficient equity, banks’ assessment of their loan servicing ability is the most important driver of the maximum amount that can be borrowed. Banks typically use a net income surplus test for originating mortgages, which is designed to ensure customers will have enough residual income after mortgage and other commitments to meet essential living costs. This can be a reasonable framework for mortgage loan decision making, but only if the underlying assumptions about living costs, income variability and the potential for interest rates to rise are prudent.
The Reserve Bank has recently begun collecting data on TDTIs at the time of loan origination, with the cooperation of the five largest banks. While the data are not fully consistent across banks, they are broadly indicative of industry trends. A high proportion of loans are originated at high TDTIs, with around 40 percent by value at a TDTI of above five. Under a standard 25-year mortgage contract and a 6.5 percent mortgage rate, these borrowers would be dedicating about 40 percent of their before-tax income to servicing mortgage payments. Although historically low mortgage rates are currently boosting mortgage affordability, elevated TDTIs increase vulnerability to a decline in labour incomes or an increase in mortgage rates.
High income borrowers tend to have significantly more net income surplus for any given TDTI, given that essential expenses do not rise proportionately with income. The risks around high-TDTI lending are therefore somewhat mitigated by borrowers tending to have high incomes. Around 70 percent of all high-TDTI lending is to borrowers with income above the New Zealand household average of about $90,000 (figure C1). Moreover, around 40 percent of lending is to borrowers with incomes of above $140,000. Loans to these borrowers are substantial, often in excess of $1 million, and are likely to be a significant factor enabling rapid increases in Auckland house prices.
Figure C1: Distribution of borrowing by borrower gross income (May 2014 to September 2015, % of total lending)
About 60 percent of all investor lending is at a TDTI of above 5, with around 25 percent at a TDTI exceeding 7 (figure C2). Part of the reason for high TDTIs is that most investors do not need to meet living expenses out of the rental income they earn. Investors will also often have significantly lower tax bills relative to a homeowner with a similar income, because of their ability to deduct interest costs when calculating taxable income. Nevertheless, the proportion of investor lending at high TDTIs may also indicate elevated risk. By contrast, the share of high TDTI lending is much lower for first home buyers. In the data, borrowers are currently classified by the purpose of the most recent loan, so some ‘owner occupiers’ (but no first home buyers) are likely to also hold rental properties.
Figure C2: Total debt-to-income ratio by buyer type (May 2014 to September 2015, % of lending to each buyer type)
With global interest rates at historically low levels, serviceability calculations have been an area of concern internationally.2 A number of countries including Australia, Canada, the US and the UK have provided guidelines or rules effectively creating minimum standards for lenders when originating loans. This may be done for prudential reasons, consumer protection or both. Recent policy scrutiny of mortgage origination in Australia has focused on both objectives.3 In some cases, standards place a practical limit on the amount that can be borrowed. For example, new UK rules arising after the Mortgage Market Review require lenders to conduct a full affordability check on mortgage borrowers.
In New Zealand, the Responsible Lending Code, released by the Minister of Commerce and Consumer Affairs in March 2015, has some application to mortgage lending. However, the code is less prescriptive around mortgages than in countries like the UK and Australia. On the prudential side, the Reserve Bank’s speed limit on high loan-to-value ratio lending will effectively act as a constraint on TDTI for some borrowers. The Reserve Bank also imposes risk-based capital requirements on mortgage loans, and promotes market and self-discipline through governance and disclosure standards. For banks that use Internal- Ratings Based capital models, capital requirements for mortgage loans typically depend on a measure of the borrower’s ability to service the loan.
While there have not been substantial losses on mortgage loan books in New Zealand for many years, loans today are much larger relative to incomes. In the current environment of low interest rates, rapidly rising house prices, and elevated household debt, lenders need to take particular care to maintain adequate testing of loan serviceability. These tests should have sufficient regard to the risks faced by customers if interest rates rose sharply or if customers experienced a loss of income. The Reserve Bank will continue to monitor and report on the risks around high-TDTI lending, and intends to gradually expand the collection of TDTI data during 2016 to other banks.4 The data will also help to assess the effect of the altered LVR policy in increasing the resilience of bank and household balance sheets. The Reserve Bank will publish data for the system as a whole after ensuring that the data are of sufficient quality.
1 TDTI is defined as the total declared debt of the borrower, from all sources, as a ratio to gross income. See Coleman (2007) ‘Credit constraints and housing markets in New Zealand’ Reserve Bank of New Zealand Discussion Paper, DP2007/11 for more on the easing in credit constraints since the 1980s. This definition corrects that used in the print edition.
2 Obtaining comparable data on debt-to-income multiples at origination across countries is difficult. Some countries like the UK have such data for owner-occupiers, while others such as New Zealand have data that also cover investors, making the observed average multiples higher.
3 See Byres (2015) ‘Banking on housing’
4 This is likely to occur through a further expansion to the recently enhanced New Residential Mortgage Commitments Survey (which provides more information on investors and Auckland lending).