Most lenders use the same basic formula when calculating your borrowing power.
However, there can be a lot of variation in the way they assess your expenses, with some lenders require adding a buffer that seriously impact the final amount you’re eligible to borrow.
Borrowing capacity formula
Gross income – tax – existing commitments – new commitments – living expenses – buffer = monthly surplus
For example, $10,000 per month income – $2,000 per month tax – $500 per month existing credit card payments – $3,000 per month new home loan – $2,000 per month living expenses – $500 buffer = $2,000 per month surplus, which would ‘pass’ the lender’s serviceability calculator.
However the devil is in the detail! Read below to find out how each of these figures is actually calculated using the borrowing capacity formula.
Calculating your gross income
There are a number of income sources that banks will consider when calculating your gross income. These include:
- Base income: All lenders accept all of your base income in their assessment. It’s the only income type that the banks agree on!
- Overtime: Some banks will accept 100% of your overtime income if overtime can be shown to be a regular and ongoing. Other banks will only accept 50% of overtime income for assessment purposes.
- Bonuses: Bonuses are often irregular and so lenders normally ask for a 2-year history or will not accept all of your bonus income.
- Commission: Some lenders accept commission as a form of income if it has been received for at least one or two years. They are looking to see if your commission income is regular and ongoing.
- Tax-free income: Family Tax Benefits A & B are normally accepted if your children are under 11 years of age. Other tax-free income is assessed on a case-by-case basis.
- Rent: Rent income from investment properties is an accepted form of income. Lenders typically use 80% of the rent income that you receive to allow for costs such as property management, repairs and council rates.
Tax / Medicare
You may notice that different lenders assess your tax expenses differently.
This is because there are often errors in the ways that the banks calculate your tax. We’ve copied these errors in our calculators to ensure that our result matches those of the banks.
Negative gearing benefits
Most lenders will consider negative gearing benefits when calculating your borrowing power and this reduces your tax expense.
Our ‘How much can I borrow?’ calculator will deduct the interest on your investment loans before calculating your tax and Medicare expenses.
The result of this is that the banks will allow investors to borrow more than home buyers.
To discuss your options please call us on 1300 889 743 or enquire online and one of our mortgage brokers can help with your investment home loan.
Your new mortgage
Lenders will assess the repayments of your new loan at a higher assessment rate, which is typically 2% to 3% above the actual interest rate that you will pay. This is to make sure that you have a buffer in case the Reserve Bank increases interest rates.
If you choose an interest only loan then your actual repayments will be reduced, however some banks will actually lend you less! That is because they assess the repayments over the loan term less any interest only period.
The assessment rate is higher for investors!
When the real estate market is hot, it’s common for the Australian Prudential Regulation Authority (APRA) to require banks to increase this borrowing buffer for investors.
For example, for a $150,000 interest loan at 4.5% per annum, your actual repayments are $6,750 a year or $562.50 a month.
Under tighter serviceability rules, your bank may assess your borrowing power at principal and interest (P&I) at 7.50% or even higher.
So on that same loan amount, you would need to show a sufficient income to debt ratio to afford $11,250 per annum or $937.50 per month.
Your existing commitments
Banks take in a number of factors when determining existing commitments. These include:
- Existing Mortgages: Some lenders use the actual repayments for your loans whereas some use a higher assessment rate.
- Credit Cards: Most lenders will assess your credit cards as being fully drawn, whether they are or not. They will then use between 2% and 3% of the credit limit as a monthly repayment in their assessment. A few of our banks can ignore credit cards that are not used or that are paid off in full each month.
- Personal Loans: Most lenders will use the actual personal loan repayments.
- Rent-free with parents. With most lenders, living rent-free with parents will have no effect. Some lenders allow for $150 per week as a rent expense in case you need to move out of home.
If you have several mortgages, or credit cards that you are not using, then some banks will lend you much more than others.
Our mortgage brokers are experts in finding the best home loan for your circumstances. Contact us today on 1300 889 743 or enquire online and find out how we can help you.
Your living expenses
The banks will use the higher of either your estimated living expenses or their calculation of the minimum expenses for a family of your size.
In the past lenders used the Henderson Poverty Index (HPI) however in 2012 most banks switched to the Household Expenditure Method (HEM).
Either method uses a high expense for the first adult and child, and a lower expense for each additional adult and child in your family.
So how does it work if you are applying for a mortgage without your spouse? The banks will still include your spouse’s living expenses in their assessment. This is to make sure that you can still support your family and afford to pay your new mortgage.
If your spouse is working then some banks can consider leaving out your spouse’s living expenses. You will need to provide evidence of their income such as two recent payslips.
Despite calculating your debts at a higher than normal interest rate, some lenders also add in a non-existent expense known as a buffer.
For most borrowers this turns out to be a very conservative method of calculating their borrowing power and is not a true indication of what they can afford.
Once the above mentioned expenses are deducted from your gross income then you are left with either a surplus or a shortfall.
Is having a surplus enough to get your loan approved? No, lenders complete a full assessment, which is not just limited to your income. Your credit history, LVR, credit score, genuine savings and employment will all be considered in the lenders’ final decision.
If you are a higher risk borrower then most lenders will not allow you to borrow to your limit. In other words they want to see more than the minimum surplus.
To find out more about lenders’ assessment criteria and to see whether you are eligible for a loan, contact one of our brokers on 1300 889 743 or enquire online.
How do they display my surplus?
Each lender can express the surplus in a different way such as a ratio, a monthly dollar figure, an annual dollar figure or a simple pass or fail result. However in most cases your capacity to meet repayments is displayed in one of two different ways:
Net Surplus Ratio (NSR)
The NSR determines your current debt expenses, proposed debt expenses and living expenses, to establish how many times your income can cover your expenses. A NSR calculation is typically:
(After Tax Monthly Income – Total Monthly Living Expenses) / Total Monthly Commitments (New and Existing debts)
For example the ratio could be 1:1.30 which would mean that you have enough money to pay 30% more than the debt level you are applying for. A ratio of 1:0.90 would mean that you cannot afford your debts and your loan would be declined.
Most lenders require you to have a minimum NSR of 1:1.00 however for most of our customers we recommend that they keep the ratio above 1:1.05.
Uncommitted Monthly Income (UMI) / Monthly Surplus
Your UMI is the available income after all monthly expenses, including loan repayments, have been deducted from your gross monthly income. This is the way that our ‘How much can I borrow?’ calculator displays the result of each lender.
These methods are effectively the same. It is the buffers and assessments rate used by the lender that will determine which will determine your borrowing power.
Getting the right mortgage strategy for investing
In the past some lenders used a Debt Service Ratio (DSR) method to determine your borrowing power. The DSR method is based on the assumption that roughly a third of your income will go to tax, a third to living expenses and the remaining third can be used to pay for your mortgage.
The lender uses your gross income and then takes between 30% and 50% of this as the maximum amount you can use to pay for your loans.
This method is very basic and ignores negative gearing benefits and living expenses calculated for your family size, so it is very inaccurate and is now rarely used.
Other methods of calculating your borrowing power
The assessment rate used by banks can make or break, or at least slow down your plans to rapidly grow your investment portfolio.
One method we use to help our clients is to “spread the risk” by getting loans with multiple lenders.
For example, we may apply (on your behalf) for 3 mortgages with one major bank or lender so you can finance the purchase of 3 properties.
These types of banks are APRA-regulated which means you’ll have to deal with the borrowing power restrictions that come with a higher assessment rate.
However, for the next 3 properties you purchase, you may be better off applying with a non-bank lender that isn’t regulated by APRA.
You’ll pay a slightly higher interest rate but you’ll have a much higher borrowing power because you won’t be assessed at a higher assessment rate.
Apply for a loan
There are large number of factors that can determine whether your loan application is accepted or not.
Our mortgage brokers know how the banks calculate your borrowing power and how to get your mortgage approved!
There are some lenders that look beyond a simple borrowing capacity formula and ask real questions about your financial situation.
Talk to us on 1300 889 743 or enquire online to obtain a quote from a lender that will be best suit your situation.