Prioritise to improve your borrowing potential
Knowing your financial priorities is now even more important when it comes to borrowing money, in fact it will be your secret weapon. Borrowing money is necessary (for most people) when buying a home or an investment property. The debt you take on, and the order which you do it in, will impact how much you can borrow and when. Let me explain.
The amount of money you will qualify to borrow in the future will be impacted by the borrowings you take on today.
Banks and Lenders have a fiduciary responsibility to ensure they only lend you money you can afford to take on. In the current lending environment, the screws have been tightened (significantly) as APRA has mandated banks/lenders to slow down the level of borrowings handed to property buyers and/or property owners. Refer to a blog I wrote earlier this year explaining more.
Borrowing money within your means makes perfect financial sense, however the issue is the way your bank/lender treats your current loans when it comes to working out how much new debt you can afford.
Here are the main credit types (which I see in my daily work) and how they’re assessed by banks/lenders when working out your borrowing power:
- Home and Investment loans: Irrespective of the interest rate you’re currently paying on your mortgage, the servicing rate is based on ~7.5% (currently), and P&I repayments over the remaining term of your loan (or 25 years if your loan is on I/O repayments)
- Personal loans: Being unsecured debt, the loan term is usually ~5 to 7 years, and therefore the amortised repayments are high, which reduces (or squashes) your borrowing power
- Car loans (or car leases): The loan term is again usually short (~5 years on average) which adversely impacts your borrowing capacity
- Credit Cards: The credit limit reduces your borrowing amount, as servicing is based on a percentage of the credit limit, irrespective of how often you pay off your balance
- HECS debt: HECS is based on a percentage of your salary, and therefore the higher your salary, the higher the HECS repayment that is included for servicing assessment purposes
Can you see the issue? What you can afford is very different to what your borrowing capacity is as assessed by the bank/lender. Refer to a blog I previously wrote on this very topic.
To illustrate the issue, let’s say you currently have a home loan paying 3.65%. The bank/lender will assess your current home loan using a servicing rate of ~7.5%. And if you’re currently making I/O repayments (for whatever reason), the bank/lender will assume P&I repayments over 25 years.
I’m sure you can see the obvious issue in this illustration. The repayment used for servicing purposes is so much higher than the actual repayments you’re currently making.
Using a higher servicing rate is designed to build in a buffer in the event rates start to increase (which is unlikely for quite some time), as well as to stress test your current loans to ensure you can still manage your repayment commitments as you take on new debt.
The importance of prioritising
Now that you better understand how the bank/lender treats your current loans and commitments, you can see how this can be your secret weapon when planning to borrow more (new) money.
Planning ahead ensures you take on debt in a certain pecking order, to ultimately achieve the financing you want.
For example, if you want to buy your own home, but you also want to buy an investment property to create wealth, decide what’s more important and prioritise your lending requirements accordingly.
Here are some examples I come across in my daily work, which you should consider if you plan to take on mortgage debt in the near future.
- What’s more important for you? To buy a home to live in, or invest your money in one or more investment properties and rent instead? (this strategy is called ‘rentvesting’ which has become more popular in recent times)
- How important is it for you to buy a home today in a more expensive suburb? Versus buying a bit further out for less money, and at the same time invest in a second property for long term capital growth
- Are the credit cards necessary? Do you really use them or can the credit limits be reduced, or even cancelled?
- How much is left on your HECS debt? Can this be repaid in full from your cash resources?
- Is the car loan necessary? Should you buy a cheaper car for now (debt free)? Perhaps locking in the home you want at today’s prices is more important at this point
- How much is left on your personal loan? Can it be repaid in full from your current cash resources?
I’m sure there are many other scenarios and questions that may apply to you. The moral of the story is to put pen to paper and jot down what’s most important to you and plan ahead. Borrowing money in the right pecking order will ensure you meet your financing objectives, as well as optimise your borrowing capacity.
Last thing you want is to take on unplanned debt, then later stumble across the perfect opportunity which you can’t take advantage of, because you’re leveraged to the point where you don’t qualify to borrow the additional finance you need.
I hope the above information helps you in some way when you’re considering your next move.
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.