“How much can I borrow?” It’s a question I get asked all the time… and it’s the wrong one.
The right one is: “How much should I borrow.”
Because, even though mortgage regulators are cracking down on how much banks are lending, chances are they will still extend you too much. And it’s tempting, when you’ve found the property that makes your heart skip a beat, to close your eyes and take them up on it… without any thought for the wallet-walloping consequences.
How much is too much?
How much you can safely borrow comes down to three very simple factors: the size of your deposit (and additional cash for costs), the size of your (possibly combined) pay packet and your expenses.
Let’s start with that elusive deposit (or the equity you have in an existing home when refinancing). Ideally, you’d never make a real estate move without a 20% deposit. I say this because, not only does it give you a nice margin of safety if prices dip, it means you escape the rort that is lenders’ mortgage insurance. This is insurance for which you pay the premiums but from which a lender gets the protection.
Rampaging property prices in recent years, however, have made a 20% deposit a huge challenge for first homebuyers. Still, it isn’t wise to even think about leaping into the property market without a 10% deposit (and enough cash for costs, including a few thousand extra dollars for the requisite lenders’ mortgage insurance).
“But how do you know what a 10% deposit is?” I hear you ask.
Easy – you multiply your savings as they grow by 10 until you get a figure large enough to buy something somewhere you’d think about living.
So if you had $30,000 allocated for the deposit, you could consider paying up to $300,000 for a property. If you had $70,000, you could possibly go up to $700,000. If you’re a first-time buyer, you should stop roughly between a hovel and a stately home.
But it’s not just about the deposit and potential property value; there’s another vital test you need to perform to sanity check how much this means you’d be borrowing.
The reason is that interest rates are currently so low as to be – ironically – dangerous.
Crunching the final numbers
Contrary to popular belief, the key to your homeowner comfort is not plush couch cushions or designer bathrobes, but capping your borrowings such that you can sleep blissfully at night.
To do that you need to familiarise yourself with a concept called mortgage stress, which – as implied – you never want to experience.
Thanks to the larger loans Aussies are taking out just to get a foot on the property ladder, the severe mortgage stress felt in the late ‘80s and early ‘90s would today be experienced at an interest rate of just 8%.
Mortgage stress occurs when interest rates rise to such an extent that you find yourself tipping more than one-third of your before-tax household income into your home loan. You want to give yourself enough breathing space to ensure that never happens.
It might seem unnecessary when rates could well stay at these historic lows for a good while yet and then rise only slowly? Point taken. But remember, they increased six times in just eight months after the world nearly fell off a financial cliff thanks to the credit crack up.
And forget what you’ve heard about the 17% interest rates of the late ‘80s and early ‘90s. Thanks to the larger loans Aussies are taking out just to get a foot on the property ladder, the severe mortgage stress felt then would today be experienced at just 8%.
Now that I have your attention, the final step to finding your safe borrowing ceiling is figuring out the loan repayments you’d need to make if you borrowed what the above deposit test suggested.
Just multiply your annual before-tax salaries by 0.3333, then divide the result by 12. So if you bring home $150,000, you would get $49,995, divided by 12 – or $4166.
This gives you the amount you should be able to comfortably afford to pay each month.
But you also want to mortgage ‘stress test’ this for rate rises.
We’ll use the $70,000 deposit and a potential $700,000 property. Use unos’ online repayment calculator and plug in a competitive 4% rate for a loan of $630,000 with no fees… at $3325, you should be able to cover monthly principal and interest repayments without a problem.
But what if rates rose to 7%, or more than $1200 extra a month? You’d be nearly $400 into mortgage stress.
So the sensible move would be to reduce what you borrow to keep safe in the event of a 3 percentage point rate rise: $590,000.
Lenders are now supposed to do this for you. But there’s no one with your best financial interests more at heart – forget how much you love a property – than you.
This information is general in nature and you should always seek professional advice when making financial decisions.
Nicole Pedersen-McKinnon is a commentator and educator who presents her Smart Money Start, fun financial literacy incursion, in high schools around Australia. Follow Nicole on Facebook at Nicole Pedersen-McKinnon Money.