It’s the question that ranks as one of the most important for prospective homeowners: “how much am I able to borrow?” The truth is, that question is probably best expressed as “how much is a lender willing to give me?”
The response to both questions is “well, it all depends”. So what are the factors that lenders consider when they calculate how much someone is able to borrow to buy their home or investment property?
The first thing to remember is how competitive the home loan market is. Lenders want your business, and they are prepared to offer deals to improve their chances of having you as a customer. Loans, after all, are a very lucrative source of income for Australia’s financial institutions.
But lenders need to balance this against the risk of customers not being able to pay back their loans. It’s a big hassle for them to go through the process of restructuring payment schedules or levels after customers run into financial hardship. It’s an even bigger headache for them if they need to sell a property to recoup their losses. That’s why they spend a lot of time assessing customer credit ratings and credit scores.
But this isn’t about them: it’s about you. No one wants to be left if a situation where they are unable to afford repayments on the biggest financial commitment they are likely to make. As well as finding the right home and paying the stamp duty, having to make regular home loan repayments is hard. You don’t want to face the prospect of “mortgage stress”, where you struggle to make ends meet after paying your home loan and other financial commitments.
That’s why it’s important to understand how lenders establish your ability to pay back your debt. After all, you might be living with it for up to 30 years.
How do lenders decide on my borrowing power?
The first thing to know is that all lenders have their own magic ways of assessing risk. Working out if you can get a home loan and how much you can have – your borrowing power – is generally predetermined by a number of computations based on years of experience and many thousands of previous transactions.
But each lender sees things in slightly different ways. There isn’t one general rule.
It’s important to remember that it’s not personal if a bank denies you a loan or puts conditions on you because you are seen as being “high risk”. That’s because lenders have seen it all before.
Likewise, lenders can’t easily judge your ability to earn or save money in the future. They certainly can’t over the entire length of the loan. They can only assess your borrowing limit by making intelligent guesses on how much you can afford to pay back given your current circumstances.
Every lender wants to ensure that you’re capable of paying back any home loan they might offer you. That’s why they need to work out your borrowing power before they offer you a loan.
While each has its own calculations, lenders generally take your before-tax income as a base figure. Then they will deduct:
- How much you pay in tax
- Your existing commitments
- Your living expenses
- Your prospective loan repayments
Most lenders will also build a buffer into their home-loan calculations. They do this by applying a higher rate of interest to your loan, which is often called an “assessment rate”. Some add a further buffer on top of this.
How much of a buffer is applied depends on your prospective lender’s internal policies and how likely they are to see you as a risky customer.
How does my lender figure out my income before tax?
Also known as your “gross income”, the amount of income you earn before tax could take in much more than just your salary. For instance, it may include:
- Overtime. Some lenders only count half of your overtime, while others count all of it
- Commissions you may have earned as part of your work. You have a higher chance of having your commission accepted if you have earned it regularly for several years
- Bonuses, assuming you receive them regularly. Many lenders won’t count one-off bonuses as part of your income before tax
- Up to 80% of the income your investment properties generate
- Tax-free benefits, though most lenders will judge these on a case-by-case basis
All lenders look at your salary first. But what they choose to add will depend on each individual lender.
How does my lender calculate tax?
Again, this varies on the lender. Each has their own calculations for the amount of tax they think you should be paying on your gross income.
Investors may be interested to discover that some lenders consider negative gearing when calculating tax. These deductions, which allow you to potentially lower your tax bill, may improve your borrowing strength.
What is an assessment rate?
As mentioned, lenders apply an assessment rate to build a buffer into your expected repayments schedule. They do this to feel more secure that you’ll be able to make your repayments if interest rates increase.
The assessment rate is generally 1% to 3% higher than the interest rate you’ll actually be charged on your home loan.
Investors have even more demanding restrictions. The Australian Prudential Regulation Authority will often ask banks to assess investors using an even higher interest rate than usual. This is because investors tend to strike when the iron is hot when applying for home loans. They try to take advantage of times in the buying cycle when interest rates are at their lowest and competition for lending business is at its highest. Some even choose loans that are structured to pay back the interest only, meaning that for a period the loan “principal” (the amount owed) is not being paid back.
When lenders and investors strike deals at times like these, however, they don’t always account for how repayments would increase (sometimes dramatically) when interest rates rise. History tells us this will happen at some time in the future.
What this means is that most lenders create an assessment rate based on a principal & interest loan, not an interest-only loan. You may have to prove you can afford hundreds more dollars per month than the loan will actually cost you. Again, this is to protect the lender from you defaulting once interest rates rise.
What counts as an “existing commitment”?
This relates to any regular monthly outgoings you have at the moment. Any existing home loan that you may have is taken into account, as are the repayments you make on any personal loans.
Your lender will also look at your credit cards. It is likely to assume that you have reached the limits on the cards, even if you haven’t. It will then find out how much 2% or 3% of that limit is and add that as part of your existing commitments. This covers the lender if you ever max out your cards.
Some lenders also consider rent as an existing commitment. You may not escape this if you’re living rent-free with your parents or friends. A few lenders assume a minimum rental payment of $150 per week, which they will add to your existing commitments.
How does a lender calculate my living expenses?
As well as taking into consideration your estimate for what you spend every month on shopping, transport costs, dinners out etc, most lenders now use the Household Expenditure Method (HEM) as a guide for your living expenses. This method uses national data to determine the minimum amount a family of your size is likely to spend in any given month.
Other lenders may use the Henderson Poverty Index (HPI) for the same purpose. The HPI estimates the minimum income level required to avoid poverty for a range of family sizes and circumstances.
With both methods, the lender assumes a high level of expenditure for the first adult and first child. The expenses for each subsequent adult or child are deemed to be less than the initial expense.
You may not think this is a big deal if both you and your spouse are working at the moment. But your lender wants to ensure that the first adult can cover the repayments if the second adult loses their job or runs into any other sort of financial difficulty, even if its impact is expected to be temporary.
What is my surplus?
After deducting the previously mentioned expenses from your income before tax, your lender creates a surplus figure. In some cases, this might become a deficit if your expenses outstrip your income.
Your surplus is the amount of money the bank estimates you will have left over after dealing with all of your financial commitments. The larger your surplus, the more chance you have of getting approval for your home loan. Most lenders have a minimum surplus figure that they will want you to exceed.
But your surplus isn’t the only thing your lender will take into account. It will also want to see that you have a stable job, a good credit history and genuine savings. The amount you’re looking to borrow – expressed as the loan to value ratio (LVR) – will also help determine if you receive approval.
Lenders have different ways of displaying your surplus. Most use one of three methods:
- Uncommitted monthly income (UMI). This is a single dollar figure that amounts to what’s left over once all of your monthly expenses are taken away from your gross (before tax) income.
- Debt service ratio (DSR). This method calculates a borrower’s monthly expenses as a proportion of monthly income. Lenders may set a maximum DSR at 30-35%.
- Net surplus ratio (NSR). This figure expresses how much of your income will be left after you pay all of your expenses. The following formula is used to assess the NSR:
Monthly income after tax – living expenses / Monthly debt repayments
A ratio of 1:1 shows that you earn exactly enough to cover all of your outgoings, with nothing left over. Ideally, you want a higher ratio than this. For example, a ratio of 1:1.2 shows that you could pay 20% of your monthly expenses using your surplus. An NSR like this is likely to make your lender feel more confident, as it shows you have money to spare after paying your various expenses.
What to do next
Now that you better understand how a lender calculates your borrowing strength, you’re ready to move forward. Do the following before starting your home loan application:
This information is general in nature and you should always seek professional advice when making financial decisions.