Agency vows to introduce debt service ratio in loan evaluations

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Agency vows to introduce debt service ratio in loan evaluations

In its latest step to curb snowballing household debt, the government will introduce a stricter criterion for loan evaluations, the debt service ratio, this year.

The ratio measures potential borrowers’ creditworthiness by reviewing their other debt obligations, including principal, along with income.

“Since last October, we have seen the growth of household debt in Korea decelerating finally,” said Do Gyu-sang, chief of the financial policy bureau at the Financial Services Commission, in a press briefing at the Central Government Complex in Seoul on Friday. “The amount of new loans taken out from local banks by households between October and December was about 19.7 trillion won [$16.7 billion], 3.6 trillion won less than the same period in 2015.”

Do credited less volatile interest rates and improved principal payment structures for the slowdown. He explained that the percentage of fixed-rate mortgages by September had stood at 43.3 percent, nearly triple the figure from September 2012, when it was just 13.9 percent.

The Financial Services Commission now aims to increase the figure to 55 percent this year, from the original goal of 50 percent. The target rate on amortized loans, or mortgages in which borrowers pay the principal and interest simultaneously, has been set at 45 percent, up from the initial 42.5 percent.

Nonetheless, Do argued that the crux of the household debt issue remains tightening reviews of borrowers’ creditworthiness. “We must provide financial institutions with stricter guidelines for credit review,” Do said. “To do so, we will begin adopting the debt service ratio as a reference and create a new standard model.”

A lender using the ratio will review a potential borrower’s other loan obligations, such as outstanding mortgages, property taxes and credit card balances, to determine the aggregate principal payment that the borrower can provide for outstanding obligations. The lender then adds that number to the principal payment the borrower would have to provide for the new loan.

Finally, the lender divides the sum by the applicant’s annual income to figure out whether the borrower can meet the new loan’s obligations. It is a tighter criterion than the loan-to-value ratio and debt-to-income ratio currently in use by financial institutions. The debt-to-income ratio only looked at borrowers’ outstanding obligations on interest rather than principal.

When implemented, Do said the debt service ratio will become a milestone in establishing an advanced form of credit review, citing cases from the United States and England as examples.

In the United States, the Consumer Financial Protection Bureau has made it mandatory for financial institutions to review the repayment capacity of a borrower when underwriting a new loan. The bureau requires “mortgage lenders to consider the consumers’ ability to repay home loans before extending them credit.” It gives specific criteria to evaluate when underwriting a new mortgage, including “current or reasonably expected” income or assets, monthly payments in other outstanding loans, monthly payments on mortgage-related obligations and credit history, to name a few.

If the applicant’s debt service ratio is less than or equal to 43 percent, the bureau says the borrower more or less meets basic criteria, though it leaves room for exceptions. Banks in the United States abide by this standard; some make it even stricter. Wells Fargo has set its preferred debt service ratio at 36 percent, lower than the 43 percent required by the Consumer Financial Protection Bureau.

“In 2017, we will only require banks to use the debt service ratio as a reference point while developing a standard model,” Do said. “Then in 2018, we will require each institution to launch their own trial model, before officially establishing the debt service ratio as a comprehensive credit review standard in 2019.”

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