Sarah earns $80,000 annually and wants to borrow $400,000. What is her debt-to-income ratio?
Correct Answer
B) 5.0
Debt-to-income ratio is calculated by dividing the loan amount by annual income. $400,000 ÷ $80,000 = 5.0. This ratio is a key lending criterion that banks use to assess borrowing capacity and serviceability.
Why This Is the Correct Answer
$400,000 ÷ $80,000 = 5.0. In New Zealand the Reserve Bank's debt-to-income measure is total debt as a multiple of gross annual income, so Sarah's multiple is 5.
Why the Other Options Are Wrong
Option A: 4.0
4.0 would mean $320,000 of debt on an $80,000 income.
Option C: 6.0
6.0 would mean $480,000 of debt; $400,000 is five times her income.
Option D: 7.0
7.0 would mean $560,000 of debt, well above what she wants to borrow.
Deep Analysis of This Finance Question
The debt-to-income ratio (DTI) is a fundamental lending metric that measures a borrower's total debt obligations against their gross annual income. In this case, Sarah's DTI of 5.0 means she's seeking to borrow five times her annual income. This calculation is crucial in New Zealand's lending environment, particularly following the Credit Contracts and Consumer Finance Act 2003 amendments and responsible lending requirements. Banks typically use DTI ratios alongside other serviceability tests to determine lending capacity. The Reserve Bank of New Zealand has implemented DTI restrictions for banks, with most requiring ratios below 6-7 times income for new lending. Understanding DTI calculations is essential for real estate agents as it directly impacts clients' borrowing capacity and property purchasing power, affecting transaction feasibility and pricing strategies.
Background Knowledge for Finance
Debt-to-income ratio is a key lending criterion used by banks to assess borrowing capacity and loan serviceability. It's calculated by dividing total debt (including the proposed mortgage) by gross annual income. In New Zealand, the Reserve Bank has implemented DTI restrictions as a macroprudential tool, with most banks limiting lending to borrowers with DTI ratios above 6-7 times income. The ratio helps lenders evaluate whether borrowers can service debt repayments alongside living expenses. Real estate agents must understand DTI calculations to properly advise clients on realistic property price ranges and potential financing challenges.
Memory Technique
Think of DTI as driving on a highway where the 'Debt' car travels the distance of the loan amount, and the 'Income' car represents annual earnings. To find how many times longer the debt journey is, you divide the debt distance by the income distance. Debt ÷ Income = Times longer the journey.
When you see DTI questions, visualize the highway: identify the debt amount (loan), identify the income amount (annual salary), then divide debt by income to see how many 'times' longer the debt journey is compared to the income journey.
Exam Tip for Finance
For DTI calculations, always divide loan amount by annual income. Write the formula 'Loan ÷ Income = DTI' at the top of your working. Double-check your division and ensure you're using annual (not monthly) income figures.
Real World Application in Finance
As a real estate agent, you're working with first-home buyers Tom and Lisa who earn $90,000 combined annually. They're pre-approved for $450,000 but are looking at properties around $500,000. You calculate their DTI would be 5.6 times income ($500,000 ÷ $90,000), which may exceed some banks' lending criteria. You advise them to focus on properties under $450,000 or increase their deposit to reduce the loan amount, ensuring their offer will be financially viable.
Common Mistakes to Avoid on Finance Questions
- •Dividing income by debt instead of debt by income
- •Using monthly income instead of annual income
- •Including only the deposit amount rather than the full loan amount
Related Topics & Key Terms
Key Terms:
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