How to work out how much you can borrow for your first home
Buying your first home is an exciting milestone, but figuring out how much you can borrow can be daunting. Understanding your borrowing capacity involves several factors, including your income, expenses, and existing debts. There are also various factors lenders utilise to ensure you will be able to meet your repayments including: household expenditure measure (HEM) and assessment rates. There are many online calculators to assist you in determining your borrowing capacity, however, it’s important to note that these additional factors may not be applied, giving you an inaccurate representation.
What is borrowing capacity?
Borrowing capacity, also known as borrowing power, is the maximum amount of money a lender will allow you to borrow to purchase a property. Borrowing capacity reflects your ability to repay the loan comfortably without causing financial strain. Lenders often use benchmarks like the Home Expenditure Measure (HEM) and apply assessment rates to account for potential future interest rate increases. It is determined by evaluating several factors, including:
- Your income
- Living expenses (expenses you will incur post settlement, for example, if you are purchasing a home to live in you will no longer include rent as an expense, but you will need to include primary residence costs)
- Existing debts (personal loans, HECS, etc..)
- Credit history
- The financial institution's lending criteria
What is the Home Expenditure Measure (HEM)?
The HEM is a benchmark used by lenders to estimate annual living expenses to ensure you can afford your loan repayments while maintaining a reasonable standard of living. It is designed to compare a persons reported annual expenses against the median average depending on various elements, including:
- Income
- If you are single or in a couple
- If you have dependents
It's based on the Australian Bureau of Statistics’ (ABS) Household Expenditure Survey, which considers the typical spending behaviour of Australians. If you declare expenses below a lender's HEM, your declared expenses will be assessed at the higher HEM amount.
How assessment rates influence your borrowing capacity
Assessment rates are interest rates that lenders use to evaluate a borrower’s ability to repay a loan, typically higher than the actual loan interest rate. Instead of assessing your loan application based on the current market rate, lenders add a buffer (usually 2-3%) to account for potential future rate increases and financial changes.
For example:
You are looking for a loan with an interest rate of 6.14%, but lenders will assess your ability to repay with an interest rate of 9.14%. If you are unable to afford the loan at a rate of 9.14% the lender may:
- Decline the loan: If the lender determines that you don’t have enough buffer to handle potential interest rate increases, your application might be rejected to protect you from future financial hardship.
- Reduce your borrowing capacity: The lender may approve a smaller loan amount, adjusting it to a level they believe you can comfortably manage under higher interest rates.
- Suggest changes: In some cases, lenders may advise you to reduce existing debts, improve your financial standing, or save for a larger deposit before reapplying.
This ensures that you could still afford your mortgage repayments if interest rates were to rise or your financial situation changed. By applying the assessment rate, lenders protect both themselves and the borrower from the risks of financial stress caused by market fluctuations, helping ensure long-term affordability. Meeting the assessment rate is essential for ensuring you won’t face financial stress if rates increase over time.
A rough example
Let’s assume:
- Gross monthly income: $9,000
- Monthly expenses (HEM): $3,000
- Monthly debt payments: $1,000
Step 1: Calculate net income
- $9,000 - $1,000 (debts) = $8,000
Step 2: Determine affordable mortgage repayments
- $8,000 - $3,000 (HEM) = $5,000 available a month for mortgage repayments.
Step 3: Estimate Loan Amount with Assessment Rate
Using an assessment rate of 9% and a loan term of 30 years, $5,000 in monthly repayments would allow you to borrow approximately $700,000.
Calculating how much you can borrow for your first home involves understanding your income, expenses, debts, and utilizing tools like the HEM and assessment rates. By carefully evaluating these factors, you can determine a realistic borrowing capacity and embark on your home-buying journey with confidence. Always consult with a financial advisor or mortgage broker to get personalised advice tailored to your financial situation.
