Debt Ratios are designed so your lender can assess whether or not you can afford to service your loans. It is also important that you understand what these ratios mean. In this article we will discuss the following debt ratios.
- Loan to Value Ratio (LVR)
- Debt Servicing Ratio (DSR)
- 28/36 Rule
Loan to Value Ratio (LVR)
The loan-to-value ratio is a debt ratio that expresses the loan amount to the value of the asset for which you are borrowing. This debt ratio is commonly referred to as LVR. It may also be referred to as a loan-to-valuation ratio.
An example of the debt ratio LVR could be where the borrower wants to purchase a property worth $1,000,000 and they have a deposit of $200,000. The LVR would be 80%. Alternatively, one may say the borrower has a 20% deposit. The lower the LVR (debt ratio), the more likely you are to be successful to gaining a loan.
Banks generally prefer clients to have an LVR (debt ratio) of 80%. If they don’t have that 20% deposit, the bank is likely to charge you mortgage insurance.
Let’s consider an example where the borrower has $100,000 deposit to purchase a $1,000.000
To calculate the LVR debt ratio:
- Subtract the deposit from the value of the property. (1,000,000 less $100,000 = $900,000 loan amount).
- Divide $900,000 by $1,000,000 to get 0.9.
- Multiply by 100 to get a percentage (0.9 x 100 = 90%)
Debt Servicing Ratio (DSR)
Debt servicing ratios come in different forms. This article is referring to personal debt and not company debt.
The most common debt ratio is DSR. The DSR calculates the cost of loan payments as a percentage of after-tax income. For example, if your home loan payments are $300 a month and your after-tax income is $1,000, you will have a DSR of 30%. When calculating the debt ratio, DSR, all loan payments are included. If you are saving to purchase your first home, repaying all your other debts, will increase your DSR and increase the chances of success when you go to purchase your house.
It is generally accepted that one should not have a DSR (debt ratio) greater than 33%. This means you should not have loan repayments that are more than one-third of your after-tax (or disposable) income.
An alternative debt ratio could be Debt-to-Income (DTI) ratio. This formular uses the Gross Income instead of the After-Tax Ratio
The 28/36 Rule
While the 28/36 Rule may not be as popular with lenders, it is a good measure for consumers.
The “28” refers to the percentage of your gross income spent on servicing your home loan.
The “36” refers to all debts.
Thus, if you have a monthly gross income of $10,000, you should not spend more than 28% ($2,800) for you home loan and home insurance. You should not spend more than 36% ($3,600) on all your debts.
How does Mortgage Insurance work?
Mortgage insurance will be required if your debt ratio does not meet the bank’s considered “safe” debt ratio. The mortgage insurance is intended to protect the borrower. This means that if you fail to meet your loan repayments, the borrower can sell the property and use the mortgage insurance to recoup any loss.
Mortgage is a one-off cost paid up front and may be added to the amount you borrow. The cost of the mortgage insurance can range from 1% to about 6.5% of the loan. It will depend on several factors used to calculate the risk of the loan. These are:
- The amount of the loan
- The quality of the property
- Borrower’s income
If the mortgage insurance is not sufficient to cover the debt, the lender may peruse the borrower for the balance.
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Conclusion
Be aware that the bank may complete a property valuation that may be lower than the cost of the property. In this case the ratios are likely to be based on the bank’s valuation rather than the purchase price.
Macro Trends displays the National Bank Debt to Equity Ratio from 2010 – 2025.
Debt Ratops have two basic formats. The first set of debt ratios relates to the relationship between deposit and loan. The second set of debt ratios relates to the relationship between loan costs and income.
Glenis Phillips SF Fin – Developer of Financial Mappers and Advice Online
Disclaimer: Financial Mappers does not have an Australian Services License, does not offer financial planning advice, and does not recommend financial products.
