Find out more about the debt service ratio that banks use to determine your capacity to take loans.
How many of you know how much you are worth, in terms of loan value, to the banks?
Did you know that you have a value to the banks?
My company Freemen recently completed a workshop to share with property investors and newbies on how to design their financial portfolios to receive millions from the bank.
Students, young working adults and even retirees worked out methods and strategies to bring in properties worth RM1.8mil, or even up to RM6.5mil, into their portfolio!
To understand how, let’s talk about your debt service ratio (DSR). It is a calculation which banks use to determine your capacity to take loans versus the amount of money you make on a monthly basis.
The DSR may differ from bank to bank, but the following is probably the most common way many banks calculate these days.
Debt service ratio or Debt / Income = or < 0.7
Where, debt is the amount of loan instalments paid (for old as well as new loans) calculated on a monthly basis, and income is one’s nett monthly income (minus EPF, Socso and taxes).
The total debt (including new loan installments) divided by the total nett monthly income must not be more than 0.7 (or 70%).
Many people think it is a rule of thumb that monthly loan instalment repayments should not be more than 1/3 of your gross monthly household income. This is an old practice of calculating the front end ratio of debt/income as < 0.3 to assess one’s ability to take a loan. In addition to the front end ratio, banks use a back end ratio to calculate the new loan instalments which is new debt/income <0.4. Therefore, for simplicity, many banks nowadays use total ratio (old +new debt)/income < 0.7.
Let me give you an example;
Ahmad works as an IT manager, and draws a fixed salary of RM5,300 (nett after deducting EPF, SOCSO and Tax). He just got married and now plans to buy a house worth RM400,000. He is currently paying RM1,300 for a car loan and his credit card bills are averaging RM3,000 per month.
Can he afford to buy this property and how much home loans can he take? Let’s calculate his debt service ratio.
Current debt commitment is as follows:
Car Loan = RM1,300 per month
Outstanding Credit Card amount = RM3,000
Banks take a 5% of outstanding credit card amounts, to be minimum monthly payments, therefore,
Credit Card (minimum) installments = RM3,000 X 0.05 = RM150
Therefore, his total monthly debt = RM1,300 + RM150 = RM1,450
Now, if you would like to know the maximum housing loan Ahmad can afford, then you just have to do the following:
[debt + (maximum new loan installments)] / income = 0.7
| Maximum new loan installments | = (0.7 x income) – debt |
|---|---|
| = (0.7 x RM5,300) – RM1,450 | |
| = RM2,260 per month. |
Assuming Ahmad can take a 30 year loan at 6% interest rate, an installment of RM2,260 can allow Ahmad to take a loan of RM376,950 (you can use free home loan calculators online to determine the value).
Therefore, if this is Ahmad’s first residential property, he can afford to buy a house worth RM400,000 with a 10% down payment and a loan of RM360,000.
I hope this illustration gives you a better view of how to calculate your DSR. In my following article, I will share how you can design and maximize your investment portfolio using the DSR ratio.
Till then, happy investing!
Michael Tan is the founder of Freemen, which provides educational courses helping individuals achieve financial independence through property investment. It also has an affiliated investment club for course graduates called the Real Estate Tycoon Club. More information from www.Freemen.com.my
