Are you looking to invest in property but are unsure of what your borrowing capacity is?
Most first time buyers (and even some seasoned investors) don’t have an informed understanding of exactly how much money they can borrow from the bank to invest in property. And without this vital information, it’s impossible to start looking at the market to see where you can buy.
So how do lenders calculate your borrowing capacity? Where do you stand?
There are really four things that lenders look at when assessing your borrowing capacity; salary, other income, living expenses, and dependents.
Let’s take a closer look at each of them.
The first thing a lender looks at when it comes to your borrowing capacity is your income and salary. Your most common source of income is your PAYG, which is the base salary you earn when employed by a company.
If you are self-employed, it’s a slightly different process. You will have to consider things such as depreciation, interest and net profit, for example.
Lenders will also consider overtime, penalty rates and bonuses as a part of your assessable income, but they will most likely want to see these things over a two year period so that they can average it out.
In terms of documentation, most lenders will be happy if you provide two consecutive pay slips that show a year-to-date tally of your salary, or the financial statements of your business if self employed.
All of these elements will be considered for the purpose of assessing your income and your financial capacity to pay back a loan amount.
Do You Have Other Sources of Income?
As well as your salary, lenders may consider other sources of income when determining your borrowing capacity. Rental income is an obvious example of this if you own and rent out an investment property. As a standard rule most lenders will take into account 80% of your rental income, so they can build in a buffer for vacancy rates or other circumstances.
What About Your Living Expenses?
On top of your income, lenders will also want to consider your living expenses when they are assessing your capacity to borrow money.
Most lenders break up your living expenses into discretionary and nondiscretionary expenses. Nondiscretionary expenses carry more weight in their loan assessment, because you are likely incurring these costs without any choice.
When calculating your borrowing capacity it’s really important to outline an accurate estimate of your living expenses, because they will determine how well you can service (repay) the loan. The cost of your loan and repayments at a rate that the bank determines, plus living expenses, will calculate what your surplus is. You need to have a surplus in income to be able to afford the loan.
How Many Dependents?
The other key thing that plays into this calculation is dependents. The more dependents you have, the lower your borrowing capacity will be.
A study by the National Centre For Social And Economic Modelling (NATSEM) found that the average middle-income family will spend over $450,000 on an individual child by the time they are 24 years old. This is a significant ongoing cost that a lender needs to consider when calculating your borrowing capacity.
Lenders use what is commonly called HEM, or the Household Expenditure Measure, for calculating living expenses based on the number of dependents and the size of your household. HEM is calculated as the average ongoing spend for essentials such as food, utilities, transport, communications and children’s clothing, as well as some discretionary expenses such as eating out, alcohol and childcare.
In combination, your salary, other income, living expenses, and dependents, will determine your borrowing capacity with a lender. But should you borrow everything they offer?
Should you borrow at full capacity?
At the end of the day your ‘borrowing capacity’ in the eyes of the bank, and the amount we recommend you to borrow, aren’t always the same. It’s about how much you can afford.
We always encourage clients to put together a living expenses and income budget so that they can see what they can truly afford. This is especially important with the current level of property prices and people extending themselves beyond their means. The bank’s can be flexible in this situation. So it’s important to challenge your calculations and build in a living expenses buffer of your own, because you want to comfortably service the mortgage and make sure there is no undue financial strain on the household.
Generally speaking, lenders will assess the serviceability of a loan based on the current interest rate, with a couple of percent built in as a buffer on top. For example, let’s say your mortgage rate is 4%, your bank is likely considering serviceability and repayments on something more like 7.25%, as an estimate.
Do you have a better idea of how to calculate your borrowing capacity after reading this article? Your best option is to review your current financial situation with a broker to determine how much you can borrow.