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Loan serviceability

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How much can I borrow? This is the most common question asked by home buyers and should be answered before you go shopping for your dream home or investment property. Knowing up-front how much you can spend will save you disappointment later.

The maximum size of the loan you can manage is largely determined by what is known in banking parlance as “serviceability”. Serviceability is your ability to meet, or service, your home loan repayments. Broadly, it is calculated by deducting your expenses and other commitments from your income and is expressed as follows:

Gross monthly income - tax - existing commitments - new commitments - living expenses - buffer = monthly surplus (aka Net Income Surplus or NIS).

This basic formula (or variant thereof) is used by lenders to ascertain your borrowing power. But each credit provider will have different rules for how it calculates the various component parts. For example, lenders will adjust income down, load expenses up and add an interest rate buffer based on their individual criteria.

It’s important to note that all income is not the same which is why lenders treat individual elements differently. The exception to this is base salary which - as a steady and predictable source of income - is accepted at face value by credit providers in their loan assessment calculations.

Other income, however, is discounted as it is not guaranteed. A classic example is overtime where banks will accept, say, 80 per cent of overtime. But if overtime is regular and ongoing and an integral part of someone’s job (police and nurses), it is typically considered in full for serviceability purposes.

Lenders will also accept non-salary items such as bonuses and commissions as income but not at full value as they are less certain than PAYG income. A reduced portion may be taken into consideration as long as there is a history (say, two years) of receiving such payments.

Rental from investment properties is another acceptable form of income, but is given a “haircut” by most lenders. An arbitrary amount (circa 20 per cent) is trimmed off rental income to allow for costs such as property management, council rates and, of course, periods of vacancy.

As well as revealing your income when applying for a loan, you must also declare all your living expenses including the amount you spend on groceries, utilities and entertainment. Living expenses vary from household to household. It follows that a young couple with no children will have fewer expenses than a family of six.

Most Australian lenders use the Household Expenditure Measure (HEM) to calculate the living expenses of mortgage applicants. The HEM is based on 600 items in the ABS Household Expenditure Survey. It includes expenditure on absolute basics (food and clothing) and discretionary basics (alcohol and childcare) but excludes non-basic expenses (overseas holidays).

Your lender will compare the living expenses figure you provide with the relevant HEM calculation of the minimum expenses for a family of your size. The higher of these two figures is then used to determine how much you can afford to borrow and comfortably repay.

Another step in calculating how much you can borrow is to subtract the monthly repayments on any existing debt and the monthly repayments on any new debt. Finally, prudent lenders will increase the interest rate on repayments by circa 2 per cent. This creates an interest rate “buffer” that helps ensure you can still service your loan when rates rise.

Once all the above inputs have been computed, the resulting number is your NIS (Net Income Surplus). This is the surplus income available to you after taxes, living expenses and financial commitments. As noted by the banking regulator, APRA, “for most banks, the crux of the lending decision is whether or not the NIS is positive”.

This however, as APRA notes, “is a simplification, as clearly banks also take into account qualitative factors including whether the borrower is an established customer or not, any past default history, industry of employment and location of the collateral”. Also, your Loan to Value Ratio - the proportion of money you intend to borrow compared to the value of the property - will impact the amount you can borrow.

Finally, always remember that you must be comfortable with the quantum of the debt that you take on. Just because a lender is prepared to offer you a $500,000 mortgage, does not mean that you must accept this level of indebtedness. While you may be able to afford a larger loan, the trade-off will likely be the absence of a social life if you overstretch yourself financially.

Take care not to become a victim of mortgage stress.

Paul J. Thomas, CEO


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CEO Paul Thomas