How much you can borrow is not the question, how much can you afford to pay is the key.
The internet is littered with calculators that give you some ridiculous amount that you can borrow. Most calculators take into account a few basic numbers and spit out a result that makes the eyes water.
They work out this vague notion of how much you can borrow and lead us to believe it’s how much can you afford.
The mortgage industry as a whole is undergoing some pain at the moment. The focus is to accurately assess people’s living expenses to ensure they can pay back their loans without hardship. Industry regulators and the Royal Commission are driving this more than an inherent sense of doing the right thing in the industry.
The ‘darling’ of the moment is peoples living expenses. The theory is accurately assessing living expenses will reduce the likliehood of people defaulting on their loans.
Until recently banks and lenders used benchmark living expense figures such as the Henderson Poverty Index or the Household Expenditure Model(HEM) to assess your living costs. A single person spends this much per month, a married couple with two kids it’s this much etc.
The new norm, is collecting peoples actual living expenses and comparing them against the HEM. If your stated expenses are lower the lender will use the HEM. If your stated expenses are higher they use your numbers. The trick here is if your expenses are lower you get a ‘please explain’. Why don’t you spend so much and what do you do with the surplus?
If your expenses are higher than the HEM, your borrowing capacity decreases.
But what about affordability?
The real question we don’t ask is ‘how much can you afford’ to pay each week, fortnight or month on your loan repayments? This not a simple question to answer off the cuff. It takes thought and dare I say it responsibility on the part of the borrower to work this out, before applying for a loan.
There is effort involved working through your household cashflow. Understanding how much comes in, how much goes out and how much is left over. In effect a budget. Your calculations have one main purpose; to answer your own question of how much can you afford to pay.
Three levels of affordability
How much can you afford to pay? There are three numbers you need to work out;
- Comfortable-The amount that will fit ok into your budget. It’s not going to stretch you too much and even if interest rates go up you can tweek your budget to cover the increase.
- Stretch-As it sounds, this is the maximum you can afford. You know if you are taking this to the limit, it will take serious attention to your budget to keep up the loan payments if rates go up.
- Walk in the park- You can easily cover your repayments with plenty to spare.If fact you’ll increase your minimum repayments to pay off your loan early.
My suggestion is to avoid the stretch amount at all costs. A small increase in interest rate will put you in a difficult position. Try and work around your comfortable number, it will give you the flexibility to cope with the ups and downs of interest rates.
How much can you afford to pay and borrowing capacity.
Now you know how much you can afford to pay, you can work backwards and see what this means in terms of the amount you can borrow. Ask a professional mortgage broker to do this for you. Once you have this number, your broker can assess your borrowing capacity with different lenders and find those that fit.
Begin with the end in mind
This approach starts with the end point that is how much can you pay and works backwards. You get a loan amount and your borrowing capacity. You will be sure you’ve already worked out how much you want to pay each month before you’re confronted with an unrealistic borrowing capacity.
Granted you will still have to proceed through the lenders process which works the other way around. I can’t see this changing anytime soon, but at least you know the end result is where you want to be.
You will be tempted
Borrowing capacity calculators will show you can borrow more than you have decided and you’ll be tempted to borrow more. You may think you’ve been to conservative with your calculations of what you can afford to pay or, perhaps we could get that bigger/better/nearer house than we thought.
This is only natural. But, think hard before your emotions override your common sense.