How HECS affects your borrowing capacity and should you pay it off before buying a home?
For many Australians, a Higher Education Contribution Scheme (HECS) debt is a common financial obligation after university. While it is interest-free and repayments are income-dependent, it can impact your ability to borrow for major purchases such as a home. Understanding how HECS affects your borrowing capacity and whether you should prioritise paying it off before buying property is crucial for making informed financial decisions.
How HECS affects your borrowing capacity
When applying for a home loan, lenders assess your financial situation to determine your borrowing capacity. HECS debt affects this in the following ways:
1. Reduced borrowing power
Lenders calculate your borrowing capacity based on your income, expenses, and liabilities. Since HECS repayments are deducted from your taxable income once you earn above the threshold, they reduce the amount of net income available for loan repayments. This means lenders may approve you for a lower loan amount than if you had no HECS debt.
2. Higher debt-to-income (DTI) ratio
HECS is considered a financial liability by lenders, contributing to your debt-to-income (DTI) ratio. A higher DTI can make it harder to qualify for a loan, especially with stricter lending criteria in place.
3. Serviceability calculation
Banks assess your ability to service a loan by factoring in all existing financial commitments, including HECS. Even though HECS repayments are relatively low compared to other debts, they are still included in serviceability assessments, potentially limiting your loan approval amount.
Should you pay off your HECS before buying a home?
Deciding whether to pay off your HECS debt before purchasing a home depends on several factors:
1. Indexation of HECS debt
HECS debts are adjusted annually in line with the Consumer Price Index (CPI), effectively increasing the debt balance to maintain its real value over time. In 2023, the indexation rate was notably high at 7.1% due to elevated inflation levels. However, recent legislative changes aim to alleviate this burden. Starting from June 1, 2024, HECS loans will be indexed according to the lesser figure between the CPI and the Wage Price Index (WPI), limiting the impact of inflation on loan balances. Additionally, refunds for 2023 and 2024 indexation rates will be processed automatically by the Australian Taxation Office (ATO).
2. Impact on deposit savings
Using savings to pay off HECS may delay your ability to save for a home deposit. Since lenders generally require a minimum 20% deposit (or 5% with Lenders Mortgage Insurance), paying off HECS early might not be the best use of your funds if it means postponing your home purchase.
3. Borrowing capacity vs loan affordability
If your HECS debt significantly reduces your borrowing capacity, paying it off could increase the amount you qualify for. However, it’s essential to balance this with the affordability of loan repayments once the mortgage is taken out.
4. Other debts and financial goals
If you have high-interest debts, such as credit cards or personal loans, it is more beneficial to pay those off first. Additionally, if paying off HECS would strain your finances, it may be better to focus on saving for a deposit and maintaining a strong credit profile.
Examples of when to pay off HECS vs when not to
Example 1: When paying off HECS is a good idea
- Income: $120,000 per year
- HECS balance: $10,000
- HECS repayment rate: 7.5% (based on 2024–25 rates for income between $119,310 and $126,467)
- Annual HECS repayment: $9,000
In this scenario, the individual's HECS repayments significantly reduce their net income, affecting their borrowing power. Paying off the $10,000 HECS balance could increase their borrowing capacity, enabling them to secure a loan for the desired home.
Example 2: When keeping HECS is a better choice
- Income: $70,000 per year
- HECS Balance: $25,000
- HECS Repayment Rate: 3.0% (based on 2024–25 rates for income between $70,619 and $74,855)
- Annual HECS Repayment: $1,750
- Saved for House Deposit: $50,000
Using $25,000 of the deposit savings to pay off HECS would reduce the deposit to $25,000, potentially requiring Lenders Mortgage Insurance (LMI) or resulting in a higher-interest loan. In this case, maintaining the HECS debt and utilising the full $50,000 as a deposit is more advantageous, as it helps avoid additional loan costs and secures a better mortgage deal.
Key takeaways
- HECS debt reduces your borrowing capacity due to its impact on your net income, DTI ratio, and serviceability calculations.
- Paying off HECS before buying a home may help increase borrowing power but could delay saving for a deposit.
- Given its indexation to inflation, HECS debt may increase over time, but recent changes aim to limit this impact by tying indexation to the lesser of CPI or WPI.
- The decision to pay off HECS early should be based on your financial situation, deposit savings, and borrowing needs.
- Real-life examples highlight when paying off HECS makes sense and when it might be better to keep it.
Ultimately, while HECS does affect borrowing capacity, it is not always necessary to pay it off before buying a home. Consulting with a mortgage broker or financial advisor can help you determine the best strategy based on your circumstances.
