Borrowing Power vs. Affordability: Can vs. Should
There are plenty of resources out there for new investors to calculate their borrowing power. But if these calculators are so accurate, how is it that people wind up borrowing beyond their means? Unfortunately, borrowing power and affordability aren’t always the same thing, so we thought we’d step you through the differences. It can make a big difference to your quality of life in the future.
If you don’t know what your borrowing power is, there are plenty of banks and lenders who are happy to run the numbers through their calculators and spit out a figure. But have you noticed how those figures change when you go from provider to provider? That’s because each bank uses something called an assessment rate to determine how much you can borrow.
Of course, the assessment rate isn’t the only contributing factors. Banks can include a raft of other information to determine how much they’re willing to lend you. This might include available credit and/or debt (which can include your Afterpay/ZipPay totals!), and any associated histories. Your deposit and the type of loan also make a difference, as do your living expenses — not to mention any dependents. Lenders may also treat certain types of income differently (such as casual, full-time etc.), so if you’re not in full-time work, it may well be worth shopping around to find a lender who’ll treat you well.
What’s an assessment rate?
The assessment rate is an amount the bank adds to their standard variable rate — the latter is usually informed by the Reserve Bank of Australia. They add this amount in order to create a ‘buffer’ in case of interest rate rise, regardless of how unlikely a rise might seem in the current climate, to protect you and their investment. Don’t forget, banks don’t want you to default on your loans either.
As we discussed in our February blog post on avoiding tears for first-time home buyers, affording your mortgage repayments is the bare minimum. People with the same income can live very different lives with very different financial obligations, so what happens if the bank’s algorithm doesn’t fully take into account your financial situation?
This is where ‘affordability’ becomes an issue. If a lender hasn’t asked the right questions, or if your circumstances have changed, it may be that your ability to repay your loan has also changed. The same may be true if you kept a few things to yourself during the loan application process. Ultimately, if the money coming in doesn’t cover the money going out, you’re going to run into problems. How soon you run into those problems depends on the size of the buffer you left yourself with loan repayments.
This is why it’s important not to just take the highest amount offered to you: it gives you the least amount of space for incidental expenses. Before you agree to a loan, look at your household expenses. Not just things like rent, petrol and loan repayments, but also annual expenses like your car registration, any insurance premiums and potential new expenses (such as rates and increased utility bills), and upkeep on your new property. Have you also factored in things like moving costs and new furniture for your new home? Expenses can add up very quickly. Also, while you may find your way into some money, whether through a raise, a bonus or a timely sale of an asset, those temporary boosts are only that. You cannot rely on them to keep you afloat in the months and years ahead.
Cash flow is always king, so it’s important to be aware of every dollar and where it needs to go. This doesn’t mean that you have to stop having fun or curb all non-essential expenses (you’ll have to pry our streaming services from our cold, dead hands), just that if you’re likely to want to let your hair down a bit, you should consider borrowing less.
Buying a house is taking on a responsibility, so it’s important to make sure that you can support that responsibility. While lenders may give you some wiggle room with their assessment rates, they can only do so much. At the end of the day, it’s up to you to work out how much you can reasonably and comfortably commit to buying a home, and make a decision based on that total. Even if it involves keeping track of receipts, automatic payments and annual expenses for a full 12 months, it’s time well-spent — and money well saved.
While you might stare wistfully at the houses you could have possibly afforded, you’ll sleep easier knowing that you’ll get to stay in this one for far longer, and keep your Netflix subscription.
If you’re interested in reading more about making the right decision first time, you can read our blog post 6 tips to avoid tears for first-time home buyers. If you have any questions, we’d love for you to contact us.