When it comes to borrowing money, many people confuse their borrowing capacity with their affordability. So let’s clear up this issue which may help you when managing your cash flow in the future.
When you borrow money, the bank or lender has a responsibility to ensure you have the financial capacity to service the mortgage repayments now, and into the future.
No one can predict the future and issues will come up, however the bank will assess your borrowing capacity on the basis of your current financial situation, as well as factor in a buffer in case interest rates were to rise. It’s a way of stress testing your capacity to service the debt now and into the future.
The bank works out your borrowing capacity by using what’s called an ‘assessment rate’. Each bank and lender has their own assessment rate and it’s based on the bank’s appetite for risk. Which is why your borrowing capacity can vary significantly from one lender to another.
On top of the assessment rate, the bank will also apply certain other factors and will load your existing (other) loans by a buffer, they account for all your incomes including wages and rental income(s), and they also include all your credit cards on the assumption that you have maxed out the limit (whether you have or not).
The bank also accounts for the number of financial dependants you have in your household, and apply a cost of living based on the higher of a) your declared living expenses, or b) the number worked out by their Actuaries. The cost of living amount used by the bank may or may not be the same as what you and your household actually spends. It can be more and it can be less. We’re all different and this is where the issue of affordability raises its head.
Your affordability on the other hand has more to do with your lifestyle and choices which you make on a day to day basis. The choices you make and how you spend your money will differ to the person next to you, and therefore the cost of living that the bank uses to determine your borrowing capacity seldom matches your actual spending pattern. Your lifestyle is unique to you!
When you take on debt, you have a responsibility to you (and your family) to ensure that you are not going over your head and that you know your numbers. As the saying goes, if you fail to plan, you plan to fail.
Before you take out a mortgage or any other type of debt, follow these simple rules:
1) Know your current cash flows (money in and money out). We can assist you with this and have templates which may help you (just ask us).
2) Work out your current disposable income BEFORE the new debt is factored in.
3) Know what the new loan repayments will be and ensure there is adequate cash flow from your disposable household income that can easily meet the repayments.
4) Know the interest rate which the new loan repayments are based on, then calculate how much the repayments would increase by if your interest rate increased by 1%, then 2% and even 3%. Can you still afford to make the repayments from your disposable household income? If not, can you fix the current interest rate to bullet proof your cash flow repayment commitments for a period of time?
5) Is the debt you are taking on worth the hassle and risk? What is it that you are financing? A holiday? A car? Or is it an asset that will appreciate in value over time and will in fact add to your wealth in the long run? (such as a property)
Don’t be overly conservative and have some faith. In the end, borrowing money is a key ingredient to creating wealth and owning a sound balance sheet for your retirement is important. Just be smart about it and only take on debt which you know you have the financial capacity to service now and into the future. Borrowing money is not the issue, it’s not having the cash flow to service the debt is where some people run into trouble. Have a safe financial buffer to play with also as this is a great strategy particularly for investors.
When it’s all said and done, it boils down to this. Serviceability is the bank’s responsibility and Affordability is yours. The bank works out your borrowing capacity to ensure you have the capacity to meet the loan repayments, and your job is to ensure that you have the financial means to meet the commitments for the new debt that you plan to take on with consideration for your lifestyle choices.