Income to Debt Ratios

Expert Advice with Todd Hunter.13/04/2016

When researching locations to invest in or calculating whether tenants can afford to rent one of my properties, one of the most important factors in this equation is – Income to Debt Ratio.
 
So what is it?
To work out this ratio you need two things, net income and the level of debt required to fund either the loan or rent. In numbers; if a person earns $1000 per week in their hand and their loan repayments are $400 per week then their income to debt percentage is 40%.  Simply divide 400 by 1000 = 40%.
 
So you’ve researched a location to invest in and want to know if there is potential for capital growth. What you need to do is research what the average household incomes are for the area. Census or council websites offer this information for free. Once you have this info there is a bit more calculating to do. You need to find the median house price for the area. Smart investors always purchase below the median. Find your price point of suitable properties and multiple the price by 90%.
 
Most buyers these days can get a mortgage to a maximum of 90% of the value of the property. Put that figure into a mortgage calculator (there are a hundred on Google) over 30 years at a Principle and Interest repayment. If the repayment number is monthly, then multiple that number by 12 and then divide it by 52 to get a weekly figure.
 
You now have your two important figures. The income and the debt figures. Now just divide them like above.
 
The chart below shows whether you are good to proceed, safe, unsafe and should run for the hills.
 
Working out whether a tenant can afford to rent your property is the other situation where I use this calculation. This one is a bit quicker. Get the tenants base net weekly wage. If the applicants are a couple, add their incomes together. Then divide that figure by your proposed weekly rent. Only use their base wage and not overtime, commissions or bonuses. This will put an extra safety buffer in there for you.
 
So working this percentage out and knowing what to do with it, is another story. So here is my guideline I use for my own properties:
 
Percentage Safety Level
   
Up to 20% Awesome
   
20% - 25% Ideal
   
25%-30% Safe, proceed
   
30% - 35% Max level
   
35% - 40% Unsafe
   
40% - 45% No go zone
   
45% - 50% Run for the hills
   
50% + Going bankrupt
 
My maximum level I like to see in locations is below the 30% when I buying property. With tenants looking to rent my properties, I like to see below 25%. That way I can factor in rental increases in six or twelve months time.
 
Why is this?
You need to look at this very practically, if you earned a net wage of $1000 per week and your mortgage or rent payments were $200 per week, then you can easily afford to live. You have to remember this is only your mortgage or rent payments. You still have living expenses like car expenses, food, electricity, entertainment etc
 
As that payment expense increases towards $300 per week then you are still OK but don’t really want it to go up anymore. At $400 per week you are tightening your belt and cutting back on may luxuries. At $450 per week you are living on 2-minute noodles and $500 per week and over you are on the verge of going bankrupt.
 
Interest rates and their effect on this equation play a very important factor in this. For instance if you have a $300k mortgage and your interest rate is 4.5% then the Principle and Interest repayment is $350 per week. That’s the maximum safe level if you earn $1,000 per week. But if interest rates increase to 5.5% in the future then your repayment increases to $392, verging on the Danger Zone.
 
Factor in a pregnancy and reduction to one income and you can see how investors can get themselves in financial stress very quickly.
 
Stay Safe – Invest Smart!
 


Todd Hunter is director, buyer’s agent and location researcher for Sydney-based wHeregroup. He is an active property investor himself and amassed a portfolio of 50 properties by the age of 31. For more of Todd's musings, visit the wHeregroup blog.


Disclaimer: while due care is taken, the viewpoints expressed by contributors do not necessarily reflect the opinions of Your Investment Property.

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