One of the most important factors in your home ownership journey is the amount of money you can – or should borrow. You want to borrow enough that you can purchase the right property for your needs, yet you don’t want to end up out of your depth in debt.
Most lenders rely on their own variation of a basic formula to calculate your borrowing power. They look at six elements of your financial situation – gross income, tax, existing commitments, new commitments, living expenses and buffer – to calculate your monthly surplus. This formula gives a good overview of your level of financial security, and tells lenders how much you are able to pay back each month. If you assess yourself based on a similar formula, you can have a realistic idea of how much you can borrow and whether you need to save and prepare a little more first.
So how do all these elements combine to assess your borrowing power?
The lender will look at all your sources of income to calculate your gross income. Sources include your base income, overtime, a two-year history of any bonuses, commission (if you have been receiving a regular ongoing amount for at least one or two years), any regular payments from a family trust and any rent derived from investment properties. If you have children under the age of 11, the lender will also include any Family Tax Benefits A& B.
Tax and Medicare
Your tax and Medicare expenses will be calculated to assess how these costs reduce the amount of your gross income.
Negative gearing benefits
If you already have investment properties and incur benefits through negative gearing, the lender tend to increase the amount of the potential loan.
Your new mortgage
When calculating how much your new loan repayments will cost, the lender will slightly increase the interest rate by about 1% to 3% to create a buffer against future interest rate rises. If you are purchasing an investment property, they will sometimes calculate an even higher interest rate, depending on the current market.
Your current financial commitments
Your ability to pay off your loan will be affected by your other financial commitments, such as ongoing debts and living expenses. Lenders will look at your existing mortgages, credit cards and personal loans to determine your financial status. Credit cards will be assessed as if you owe the maximum limit, not on how much you currently owe. And the lender will also calculate on a slightly higher interest rate. If you are living rent-free with a family member, the lender will calculate in a hypothetical rental payment to allow for a change in your circumstances.
You can present your lender with your own estimate of your living expenses; your lender will compare this amount to their own calculation of the minimum expenses for a family of your size. They will use the higher figure to make their estimation.
The lender will add a hypothetical expense as a buffer against any unexpected expenses that could affect your ability to repay the loan. The purpose of the buffer is to ensure that you are borrowing slightly less than you can currently comfortably afford.
Surplus or shortfall?
Once the lender has calculated each expense, they will deduct these expenses from your gross income. If the expenses are greater than your gross income, the result will be a shortfall. If you are living within your income, the result will be a surplus – extra money that can be used to pay off a loan. A surplus is a good first step to securing a loan, although the lender will also take into account factors such as your employment history, your credit score and your savings before making a decision.
You can use this method yourself to calculate your own surplus so you have a good idea how you can manage loan repayments once you purchase a property. This is an excellent exercise in getting a strong grasp on your budget and working out ways you can make your money work for you more effectively.