How lenders calculate your borrowing capacity in 2017

The purpose of this post is to outline how different banks determine your borrowing capacity in 2017.

How do lenders calculate your serviceability?

Lenders calculate your borrowing power by calculating your income and subtracting your assessed expenses. The left over monthly/yearly surplus is then used to extrapolate your borrowing power. This hasn’t changed.

Every lender calculator can also be broken down into individual parts. Lenders have changed how they calculate individual parts of their calculations, leading to big drops in borrowing capacity. For example, minimum living expenses are higher, assessment rates are higher, other income treatment is lower, etc.

Property investors seeking to understand borrowing capacities can ‘generalize’ lender calculators into three distinct categories:

1. The ‘APRA calculator’
Today, most banks have a lender calculator that mirrors the 2017 version of the APRA prudential practice guideline. This guideline is very prescriptive as it sets the rules for each component of the serviceability calculator. The individual parts of these calculators work like:

• 7-7.5% P&I repayment on all new & existing debt. Roughly, this means that the lenders double the actual repayment you will make to work out whether you can afford the new loan (based on $1mill debt and 4.5% actual interest rate). Higher effective assessment rates for interest only debt.
• 75-80% of rental income taken; 80% of other income taken (bonus/commissions); No negative gearing or negative gearing tied to actual interest rate; HEM living expenses.

2. Generous mainstream lenders
There are quite a few lenders out there that deviate slightly from the APRA prudential guideline. They usually diverge in one or two individual components of the APRA calculator and produce a better borrowing capacity result. For example, some of these calculators have one or more of the below characteristics:

• A 50-70% loading on actual repayments on any existing mortgage debt you hold.
• Negative gearing addbacks at assessment interest rate (7-7.5% P&I), instead of the actual interest rate you pay. This reduces the tax payable on your salary income, and therefore, increases the net income in serviceability calculations.
• 100% usage of rental income or non-consistent income sources such as overtime.

3. Aggressive calculators: non-banks
These calculators are still very much in the 2014 era. Typically, they aren’t deposit taking institutions and therefore currently fall outside APRA’s prudential practice guideline (although APRA want to change this). These lenders usually charge a premium for lending and usually involve greater finance risk, as your options to move elsewhere are very limited. They usually also have less flexible policies and products, and often have ‘price for risk’ models – for example, they usually don’t do construction loans, have stricter employment policies for their cheaper rates, drop rates by LVR bands, etc.

• Lower assessment rates.
• Small loading on OFI debt repayment or actual repayments on debt used.
• Higher negative gearing addbacks
• Lower minimum living expenses

Observations about borrowing capacities today:

• Lenders calculators produce increasingly similar results than they used to. There is less divergence between lenders. Nonetheless, they still produce materially different results for property investors. Divergences get larger for property investors as they accumulate more debt. It is these divergences that offer scope to structure finance to build larger portfolios.

• In my opinion, serviceability assessments won’t get any easier over time (we are still low rate environment). There is a far more prescriptive version of the APRA prudential practice guideline.

What are the results of these calculators?

To depict how these lender calculator works, we have run three basic scenarios to test how much someone can borrow for an owner occupier loan, on a principle and interest repayment over 30 years.
Expenses are the same across each scenario: minimal living expenses, 6k credit card, no other debts. The intention of each scenario is to show how lender calculators change for property investors specifically, and to demonstrate the differences between the three calculator segments we’ve raised above.

1. GREEN: Combined income of $140k (70k each), no property investments
2. YELLOW: Combined income of $140k (70k each), $1mill existing property investment portfolio at an 80% LVR. $800k debt at 4.5% I/O repayments with a 5% rental yield.
3. RED: Combined income of $140k (70k each), $2mill existing property investment portfolio at an 80% LVR. $1.6m debt at 4.5% I/O repayments with a 5% rental yield.




Borrowing capacities fall dramatically for APRA lenders as debt rises. For aggressive lenders, additional debt does not hurt borrowing capacity as much. It is these aggressive lenders that property investors can use to grow larger sized portfolios. Beware, there are risks of doing so and these need to be managed.



Borrowing capacities are also dramatically different between different major lenders. Some target property investors better than others. In this example, we show the ~$500,000 borrowing capacity difference for an investor with $2million in existing properties between major banks. While this gap has closed dramatically in recent years, there are still divergences between lender calculators. This offers scope for strategic and structured finance planning.

 

Great write up! Thanks @Redom

 

How do lenders assess your living expenses if I may ask? I remember getting asked about credit cards but nothing more than that really. I have only borrowed from the bank i bank with, so i suppose they know exactly what I spend on groceries and holidays.

 

Thanks @Redom Can I ask is the Income before or after tax?

Cheers

 

This has come under the spotlight more and more recently. Lenders ask borrowers what their living expenses are - this is the first method of verification. If its higher than HEM (their auto calculated system ones) they use your listed figure, if lower, they use HEM.

Some are taking it further and further and digging deeper into statements to get a more accurate guide & requestioning stated living expenses.

 

Great question. Salary income is always taxed. One or two of the middle ring calculators are better than others because they are not taxing rental income. Its clearly skirting the edges, as APRA's prudential guideline didn't mention it to this level of detail. I would assume they would have thought it was rather obvious that you need to tax rental income (as it is indeed taxed), but a few lenders don't tax it & therefore have slightly better calculators.

In the last chart, the spread between two big 4 lenders - one of the key differences between calculators is that rental income is taxed vs not taxed. Given its a $2mill portfolio at 5%, taxation differences on 100k income makes a large difference in borrowing capacity results.

 

Thanks very much for the info, very informative, cheers Redom.

 

Sorry @Redom - I meant is the combined income before or after tax.

 

Before - gross incomes used.

 

Great post.

 

Great work.

 

Redom always makes complicated finance concept easy to understand
Good work.

 

How much other income, other than from your linear work income do they take into consideration? You mentioned rents, yes, but what about other income?
For example, if franking credits from ones company are used, would these be added, if trust income from others is gifted back, will they consider it, if one had documentation (Deeds of Forgiveness, Deeds of Entitlements)?

 

Just about all income that is not "core" PAYG income is increasingly being subjected to "shading" , which means 50,60,70,80% is used, for example.

This is why bonus income, commission income etc isnt able to be used as effectively for servicing as it once was.

In a nutshell, lenders are going to continue to detune calculators for I/O borrowers to meet their reduced quota of 30%. Hoping they don't or won't is fruitless.

Removing debt or adding income ( I mean "core" salary from employment- whether that's PAYG or self employment) are therefore the two most effective tools for improving borrowing capacity . Everything else you do to increase income - bonus, commissions, extra rent etc - is pretty much shaded and you wont get full value from those efforts.

Now, if you cant increase your salary by much, you can do it by adding a cash cow - that might be NRAS ( well, not so much now that they're few and far between) dual occ, subdivision, commercial or even adding a granny flat to an existing dwelling ( subject to state and council planning laws) for example...

While the additional income from a cash cow may be shaded, the debt reduction is where the real value lies. Paying down an extra 6,7,8K of debt per year doesnt solve the borrowing capacity problem overnight, but it does provide a very strong compounding impact over 5,6,7 years and beyond... it also serves as a defensive mechanism against future I/O rate rises and P&I repayments, which will add significant extra cost to your portfolio's outgoings

Not necessary if you have no intention of adding any additional borrowing/growing your portfolio...but quite necessary if you have plans to grow. And also likely to be necessary for anyone operating their business( their portfolio) on an assumption of I/O repayments being available to them for 10-15 years , at rates of 5% or thereabouts.

#decadetodeleverage #cashcowskilldebt

 

Great write @Redom , enjoying reading it. good work

 

Agree! Another quality post @Redom

 

awesome post mate! thats helped me out a lot, i have been wondering exactly how much more borrowing power a non bank lender could give as the portfolio grows, super easy to understand, thanks a lot

 

They can hugely increase your borrowing power BUT they literally own you - there's nowhere to turn if they decide to tighten the screws. Careful planning required

 

yeah i remember you saying that, i have a pretty outlined plan of debt reduction and cashflow management, but i can run it by you when we meet up etc to sort the loan @Jess Peletier
EDIT: going to one of these lenders would be last resort though**

 

Great post!
Is APRA in the process of trying to change regulation so that they can start regulating the more aggressive non-bank lenders?