Your Borrowing Capacity & the Importance of Budgeting
by Nick Carydias, Mortgage & Finance Consultant
As a Finance & Mortgage Consultant, one of the most frequent questions I am asked when establishing a home loan for a client is ‘How much will the bank lend me?’
If the lender only takes into consideration an individual’s assets, liabilities, income and declared expenses, and not all of the costs of sustaining their lifestyle, then the calculated borrowing amount can be more than the individual requires, or is able to service.
In my opinion, the questions people should be asking are:
What is my budget? And how much can I afford to service my borrowings?
It's all well and good that a bank may lend you a lot more than you expect, but have you considered whether it is affordable; especially for the long term? This is why it is essential to budget accordingly and take all aspects of your lifestyle into consideration when calculating your borrowing capacity.
As John often says, the first golden rule for investment is ‘Do your financial planning conservatively and correctly.’
Get your budget right
A budget is imperative to know exactly where you stand and what funds you can allocate towards your loan. Itemising everything as best you can (funds coming in and funds going out) will give you a better picture in regard to monies you can allocate towards the cost of your loan, without feeling a heavy constraint on your everyday life. Even working out how much you spend on your smaller everyday costs such as petrol, milk, bread etc is essential; the more accurate you can budget, the easier it will be to manage your loan.
You don't want to fall short at the end of the month because you did not allocate enough funds for a certain expense - so it is often better to over estimate. A good calculator to assist you in determining your budget can be found through most lender websites. The Commonwealth Bank, for example, offers a useful calculator: http://www.commbank.com.au/Tools/budgetplannercalc.asp
How Lender’s calculate your borrowing capacity
When a lender calculates an applicant’s maximum borrowing capacity, it is a case of adding up numbers and using certain formulas to arrive at the answer. They will use a standard living expense figure based on whether the applicant is an individual or a couple, and they factor in certain types of income including employment income, rental property income, investment income and some family allowances. They will also include your debts such as your credit card limits (even if that credit level has not been utilised, minimum payments will be considered based on the limit of the card), personal loan limits, rent, how many dependants you have etc. What the calculator does not take into consideration is an individual’s or a couple’s idiosyncratic lifestyle expenses.
Let’s illustrate this
Consider the following scenario; Tim and Sally are both applying for a loan. Both applicants earn $70,000 and have credit card limits of $5,000. Of course, looking at these figures alone the banks will lend both individuals the same amount of money (approximately $420,000 – depending on the lender). Imagine that Sally’s lifestyle expenses are attuned to the bank’s model. Therefore, should she proceed with the loan, she would have no difficulty in servicing it. However, what the calculator doesn't know is that Tim has a more extravagant life style than Sally.
Unlike Sally, Tim can only really afford to put aside about $2,200 a month, although the bank is willing to extend him a loan requiring repayments of $2,295 per month. As you can see, if Tim was to get that maximum loan, he would be struggling to make ends meet, even though the calculator deems it is affordable for him. Now, you can imagine if Tim took this loan out and rates were to rise by even half a percent, he would be in a bit of a predicament, as his repayments would jump up to $2,427 per month. He was struggling to meet the repayments to begin with; now he would have to find ways to make up the difference. Of course in the above scenario, everything needs to be considered. That is, changes in interest rates, income, personal circumstances, etc. need to be taken into account.
So, always remember to ‘Do your financial planning conservatively and correctly’ and get your budget right, so you are comfortable in borrowing the particular amount you require and will avoid the stress of worrying about how you will meet your repayments.
To assist in taking the worry out of borrowing, consider consulting a qualified Finance & Mortgage Consultant who can help you with budgeting and advise which products would best suit your circumstances. If you would like to make an appointment with a John Hopkins Adviser, please call our Customer Liaison Office on 1300 726 082 or send us an email now.
For more information, or to arrange an appointment with a John Hopkins Mortgage & Finance Consultant, please contact our Client Liaison Officer on 1300 726 082 or click here.