How your borrowing capacity is calculated
Applying for a home or investment loan can seem daunting at times. Understanding how your borrowing capacity is calculated will help take the stress out of the process.
In my daily work, a misconception I often come across is that your borrowing power is based on your net worth (i.e. the net of your assets minus your liabilities). A sound balance sheet is important, however your borrowing capacity is predominantly based on your ‘capacity to repay’ the debt and not so much about how much equity you hold in your home or investment properties, nor is it about how much you’re worth.
If you grasp a good understanding of the key levers that determines your borrowing capacity, and how credit is assessed by the lender, you’ll be better prepared and you’ll be miles ahead of most people applying for a home loan.
As the saying goes, you can’t manage what you don’t know..!!
The key levers which determine your borrowing capacity (power) are these:
- Income sources
- Existing loans and commitments
- Living expenses
- Financial dependants
- Credit card limits
The best way to illustrate how your borrowing capacity is calculated is to use a simple example. Let’s make the following assumptions:
- Married couple with 1 financial dependant
- Both PAYG salary earners (Applicant 1 $80k pa, Applicant 2 $70k pa)
- Buying a home to owner occupier (as they are currently renting)
- Total credit card limits $6k
- No existing debts or other commitments
Based on the above information, the figures used to calculate their borrowing power are these:
- Minimum living expenses for an adult couple and 1 child is ~$3.4k p/mth. If our couple show (via their bank statements) a higher lifestyle, that higher figure will be used
- Net wages ~$9.6k p/mth (applicant 1 ~$5.1k, applicant 2 ~$4.5k). Net income is based on after-tax salary, and net of medicare levy
- Allowance for c/card ~$230 p/mth (based on ~3.8% of limit p/mth). This is included irrespective of the ongoing balance
When computing the above numbers, the maximum home loan these guys qualify for is ~$875k.
Repayments for a $875k home loan work out to $4k p/mth (based on a home loan rate of 3.7%).
If you think about it, these guys net ~$9.6k p/mth however the lender says they can only afford a loan with repayments of $4k p/mth. How can that be?
Most people can’t understand why and can’t get their head around it.
Let me clarify it for you…
Whilst our couple will pay a home loan rate of 3.7%, the lender will use a much higher rate in order to build in a buffer for rate rises and contingencies. The ‘qualifying rate’ (as it is commonly known) is 7.25%. That’s a whopping 3.55% higher than the actual rate of 3.7%. Can you see the issue?
At 7.25%, repayments work out to almost $6k p/mth for the same loan amount of $875k, yet actual repayments will be $4k p/mth.
The lender is including a buffer of $2k p/mth, which is a bit over the top if you ask me, but that’s how it works. In fact, some lenders use an even higher qualifying rate between 7.50% and 8%..!!
The $875k home loan amount will be further impacted if our couple live a higher lifestyle than the minimum of ~$3.4k p/mth (as used by most lenders).
For example, if our couple are seen to spend just $600 more p/mth, meaning their living expenses are in fact ~$4k p/mth (and not ~$3.4k p/mth), their borrowing power reduces by $100k. Yes you read it right, $100k less borrowing power for spending $600 more on lifestyle p/mth. Get the drift?
As you can see from the above simple illustration, your borrowing capacity is worked out for you based on the qualifying rate and not the actual rate you can achieve. Whilst the qualifying rate makes the biggest dent in your borrowing capacity, there are other items which you can better manage to ensure your borrowing capacity is optimised. Your living expense is a good start..!!
A few weeks back I wrote a blog on this very topic. Take the time to review it closely as mortgage finance has become more challenging nowadays. If you know the secrets and which levers to pull, you’ll have a better chance to securing the home loan you need and want.
In closing remember this. Borrowing money to buy a home or investment property is smart, and necessary in many cases, however you should only take on debt you can afford and which doesn’t create financial stress in your life.
Disclaimer: This information does not take into account your individual objectives, financial situation and needs. You should assess whether the information is appropriate for you and seek specialist advice from a qualified and licensed advisor.
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