A person’s borrowing capacity is the most money that could be borrowed from financial institutions. Lenders use a basic formula, but each one may use a slightly different method to calculate your income and expenses. Your ability to borrow money is calculated by subtracting your monthly costs from your net income (what you earn after taxes). Your ability to borrow money depends on many different things.
Borrowing Capacity Formula
To determine a client’s ability to borrow, banks employ the following formula:
A monthly surplus is calculated as follows: gross income minus (tax + existing commitments + new commitments + living expenditures + buffer).
Gross Income
When determining your eligibility for a loan, banks will look at your gross income from various perspectives. Among these are:
- Lenders typically use 100% of a borrower’s “base income” in their evaluation. It’s the sole source of income that financial institutions agree should be fully accounted for.
- If you prove that your overtime is consistent and ongoing, several banks will fully accept it. Some financial institutions count only half of the overtime pay as income.
- Lenders typically want a two-year history or refuse to take all your bonus income because of its erratic nature.
- Some creditors may count commissions as income if accrued for at least two years. They want to make sure that your commission is stable and reliable.
- Income from Family Tax Benefits A and B is exempt from taxation if your children are under eleven. Other forms of exempt income are evaluated individually.
- Lenders may consider rental income from investment properties; however, they may only count 80% of this revenue after deducting expenses such as property management, renovations, and council rates.
Existing Commitments
Banks count many monthly costs as part of your monthly obligations. Among these are:
- Individual lenders may assess loan payments at a lower or higher rate.
- Most loan providers will treat your credit card balances as if they were maxed out. The monthly repayment amount will be calculated as a percentage of the credit line, often between 2% and 3%. Some financial institutions will only report active or monthly paid-in-full credit cards. And some financial institutions are far more generous with their lending standards if you already have several mortgages or credit cards you don’t use.
- When calculating interest on a personal loan, most lenders will look at the amount repaid.
- Rent, even if you don’t pay it: Most lenders won’t increase your monthly payments if you live at home with your parents and don’t pay rent. The cost of moving out of your house is taken into account by certain lenders by adding $150 in weekly rent.
Living Expences
The banks will use your projected monthly spending or their own minimal expenses formula for a household of your size to determine how much money you will need to borrow.
Most banks began using the Household Expenditure Method (HEM) instead of the Henderson Poverty Index (HPI) in 2012.
Both approaches result in a high cost for the first adult and child in the family and a decreasing cost for each additional adult and child.
How does the process work if you want to apply for a mortgage, but your spouse doesn’t want to? Your spouse’s living expenditures will remain in the bank’s evaluation. This ensures you can keep up with your new mortgage payments and continue providing for your family.
Some financial institutions may waive the requirement to report a spouse’s income to get a loan. Two recent pay stubs or other verifiable forms of income documentation are required.
Buffer
Financial institutions will factor in your loan payments at a greater interest rate than you will be paying when determining your disposable income. Some financial institutions also charge an imaginary fee they call a buffer.
This usually needs to reflect the borrower’s financial situation accurately.
Surplus
After deducting the monthly expenses and cushion from your gross income, you will have a surplus or a deficit.
Can you receive a loan if you have a surplus? No, not on its own. Banks and other financial institutions evaluate you based on more than just your salary. Lenders will choose based on several factors, including your credit history, LVR, credit score, genuine savings, and current job.
Borrowing to your credit limit is unlikely if you are a high-risk borrower. This means that they require a surplus over and above the bare necessities.
Tax
You may find that your tax costs are calculated differently by various lenders.
This is because banking institutions frequently need to correct when calculating your taxes.
Assessment Rates
Lenders will charge you an assessment rate of 2% to 3% higher than your real interest rate on your new loan. This precaution will ensure that you are covered if the Reserve Bank decides to raise interest rates.
While interest-only loans do cut monthly payments, some lenders may offer you less money overall. The repayments are calculated throughout the remaining loan term, less any interest-only instalments.
There Are Other Ways That Banks Determine Your Capacity to Borrow
If you plan on rapidly expanding your investment portfolio, your bank’s evaluation rate could make or break your goals.
They support their clients by obtaining loans from several different lenders, reducing their overall risk exposure.
If you’re looking to buy many houses but only want to deal with one lender for the mortgages, they can do that for you.
The higher evaluation rate that comes with banking with these institutions means you will have less leeway regarding how much you can borrow.
You should consider applying with a non-bank lender not regulated by the APRA for the following three properties you acquire.
Although you’ll pay a little higher interest rate, your borrowing capacity will increase significantly because you won’t be subject to a higher assessment rate.
Conclusion
When determining your loan amount, most lenders will add a margin of interest rate to your projected rate. This is so that even if your financial situation worsens, you can still make your loan instalments. With some lenders, your borrowing capacity may be determined not by your outstanding debt but by your credit limit. Lenders may also reduce your borrowing capacity based on the perceived riskiness of your property’s location.
