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How much income should go to my mortgage?

Whether you’re a first home buyer or looking to upgrade, one of the most important rules is to know what you can realistically afford. And what you can afford isn’t the same as what you could pay if you really squeeze every last drop out of your income. It means having a mortgage you can happily live with for years to come, because it allows for some entertainment, holidays, unexpected events and other saving goals.

The Reserve Bank requires mortgage lenders to set sensible upper limits on borrowing, but how close you fly to those limits is up to you. Here’s a brief overview of some affordable borrowing limits and ideas to consider before signing up for a mortgage.

What are the CCCFA changes?

Some of the 1 December 2021 implemented changes to the Credit Contracts and Consumer Finance Act (CCCFA) require lenders to ensure the loans they provide are ‘suitable and affordable’ for each borrower. This includes them checking your income and expenses in detail, to make absolutely sure you can afford any mortgage they agree to provide. With interest rates rising, lenders are reportedly taking a more conservative approach to mortgage affordability, particularly when it comes to assessing your expenses. As frustrating as this might be, it’s likely to be in your best interests.

How to calculate mortgage affordability

Each lender will have their own policies and criteria for deciding how much they’re prepared to lend to you for buying a home. A longstanding rule, both here and overseas, provides a widely-accepted sensible guide for how much income should be spent on housing.

Known as the ‘28/36 rule’, it basically says your mortgage repayments and other regular homeownership costs, such as rates and insurance, should be no more than 28% of your income. Also, if you add your other current debt repayments (car loan, LayBuy, credit card) to your homeownership costs, the total should be no more than 36% of your income.

How to calculate your cost of housing vs income ratio

Let’s start with how to calculate the 28% part of the rule, which is sometimes called the ‘front-end ratio’. To work this out, you divide your annual/monthly/fortnightly housing cost by your total income over the same period.

The total cost of housing includes mortgage repayments and interest, house insurance and council rates. Your total income includes the incomes of everyone in your household responsible for the mortgage. It should only be your current regular income before tax, not income from bonuses, overtime, side gigs or an expected pay increase. If you’re including income from rent, flatmates or boarders, most banks will now only use about 65% of the amount in their calculations.

Here’s a monthly example:

  • Monthly mortgage repayment = $2,500
  • Home insurance premium = $100
  • Rates = $200

Total housing cost = $2,800

  • Monthly household income before tax = $10,000

Housing cost to income ratio = 2,800 divided by 10,000 = 0.28 = 28% (right on the suggested maximum)

How to calculate your debt repayments to income ratio

For this calculation, simply add any non-housing debt repayments to your housing cost and divide by your income. The goal is to be under 36%.

Here we continue with the above example:

  • Total monthly housing cost = $2,800
  • Monthly car loan repayment = $500
  • Credit card debt repayment = $100
  • LayBuy repayment = $50
  • Mobile phone interest-free purchase repayment = $35

Total monthly debt repayment = $3,485

  • Total monthly household income before tax = $10,000

Debt to income ratio = 3,485 divided by 10,000 = 0.3485 = 34.85% or 35% (just under the suggested maximum).

Although the 28/36 rule has been around for quite some time, many New Zealand borrowers are now well beyond these limits. This has been a major concern for housing market commentators in recent times.

How will the Reserve Bank calculate debt to income ratios?

In June 2021, the New Zealand government gave the Reserve Bank the authority to set mandatory debt-to-income ratios if they wanted to. This calculation would consider all your existing debt, rather than your debt repayments.

Why introduce DTI restrictions?

The new tool could be used to help contain rising house prices; prevent borrowers from being unable to service their mortgages as interest rates rise; and stop homeowners owing more on their house than it’s worth if house prices fall. Another advantage of debt-to-income ratios is they give the Reserve Bank one more tool to use instead of raising interest rates. Increasing rates can cause hardship for borrowers and have a slowing effect on the economy, as home-owners restrict their spending to meet the higher mortgage repayments.

Low deposit mortgages now further restricted

As a more immediate measure, in August 2021 the Reserve Bank announced its intention to further limit the amount of lending banks can do that’s above a loan-to-value ratio (LVR ) of 80%. It’s now limited to just 10% of all new owner-occupier loans, half the previous limit of 20% of new loans.

Consulting on DTI restrictions and interest rate floors

The Reserve Bank also said they’d begin consulting on introducing debt-to-income (DTI) restrictions and/or interest rate floors. Interest rate floors set a minimum interest rate lenders can use when calculating your ability to service a mortgage. In other words, it sets a consistent allowance for higher interest rates in the future. Many banks already use a rate of about 6%

What might DTI restrictions look like in NZ?

Instead of debt-to-income restrictions, other countries – such as Ireland and the UK – have loan-to-income (LTI) restrictions of about four. That means your mortgage can be no more than four times your pre-tax annual income. As New Zealand’s debt-to-income restrictions would include all debt (including overdraft and credit card limits), not just your mortgages, the maximum ratio is likely to be higher.

At the time of publishing this article (November 2021) there was no indication of:

  • When the Reserve Bank would introduce mandatory interest rate floors or DTI restrictions, if at all
  • Who they would apply to, such as investors or high LVR borrowers only
  • What the required values would be

However, at least one bank has introduced its own DTI restriction policy, reportedly setting a maximum DTI ratio of six. Using that value, your total debt should be no more than six times your household income.

Budgeting for other home ownership costs

It’s important to budget for all ownership costs, not just the ones mentioned above that involve regular payments. Here are some examples to consider:

  • Repairs and maintenance – painting, tree trimming, gutters, chimney sweeping, gas appliance inspections, heat pump servicing, carpet cleaning
  • Home improvements – bathroom, kitchen and laundry upgrades can be the most expensive
  • A new roof every 20 years or so
  • Heat pump replacement every 10 to 15 years

What you can afford vs what you could pay for a home

Government regulations and lenders’ policies are all designed to help you avoid getting into financial trouble; they do this by setting maximum limits. However, you could still get drawn into buying a home you can pay for today, but not afford in the years to come. Struggling financially with the risk of losing your home can be devastating, no matter how nice your home is.

The trick is to keep things real. If you’re ignoring risks just to get a home you’ve fallen in love with, it might be smart to listen to your head rather than your heart. It’s important to plan for things, like how you would manage temporary unemployment, a lingering illness or starting a family (and losing one income for a while). Getting independent professional advice from a mortgage broker, accountant and/or lawyer can give you much needed peace-of-mind.

To learn more:

To check how much you might be able to borrow, see our handy borrowing power calculator

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