How to calculate changes to your borrowing power

Hey all,

NOTE: This is a remake/update of a previous post originally posted on SS with a few new scenarios/edits.

Brokers are often asked questions about how different types of income/expenses change people's borrowing power. With the changes of late, managing ones limited borrowing power has become ever more important to build a portfolio, so it’s useful to have an understanding of how banks calculate it.

When applying for a new loan, banks generally will calculate your overall income and ensure it's higher than your overall 'assessed' expenses. The banks assess the new debt (loosely speaking) you take on at an interest rate of around 7-8% at P&I repayments.

How different types of income/expenses are treated generally depends on a number of factors, including:
(a) the type of income/expense it is;
(b) which lender you look at, they treat different types of income/expenses differently;
(c) how much you're borrowing;
(d) tax rate used;
(e) the banks assessment rate (the 'buffer') that they use to check whether you can service the new loan;
(f) other factors (do you have existing debt with them, interest rate changes, APRA changes, etc).

Given the array of factors, the most common answer given to questions about income/expense changes is that it depends.

However, for ease of use, below are some quick ‘back of the envelope' guidelines.

1. Salary/Business: Increase the average income earners salary by $10,000, will increase your borrowing power by ~$75,000.

The impact of this will fall for higher income earners, as they will pay a higher marginal tax rate. Given salary rises are potentially infinite, this is the most powerful way to increase your borrowing power long term.

2. Rental: For the average income earner, a $10,000 increase in rental income will increase your borrowing power by ~$50,000.

Can only include 80% of rental income generally. Therefore it's a bit lower than salary increases. Note there is also an implied cap with many lenders, plenty won’t take yields above 6% into consideration (CBA, NAB).

Note, when there is investment debt against rental income earned, some lenders will allow those interest payments to be ‘added’ back to offset the taxation consequences of this income (negative gearing). When included, the rental income impact gets closer to salary rises.

3. Credit card limits: Increasing your limit by $10,000, will reduce your borrowing power by ~$35,000.

Credit card limits are generally assessed at 36% p.a. of the credit limit (regardless of whether you use it or not). This reduces your borrowing power by around $35-45k. Note a few lenders will exclude credit card limits if repaid in full every month.

4. Discretionary expenses (above bank minimums) - Increasing your expenses by $10,000 p.a. will decrease your borrowing power by ~$120,000.

Given this comes out of net income, it has more of an effect than gross salary increases. Given part of APRA changes increased minimum living expense figures banks had to use, this had a large impact on decreasing borrowing power.

5. Having another dependent reduces your borrowing by about ~$35,000.

Increasing the number of dependents adds at least $250 p/m to your monthly minimum expenses, depending on your current income level and the lender used.

Note, the impact of children usually has larger impacts with changes in income too.

6. Going Interest only on a loan for 5 years instead of Principle and Interest repayments on a $500,000 loan will reduce your borrowing power by ~$35,000.

One of the changes APRA forced recently was having banks apply higher effective assessment rates for interest only debt (via shortened loan terms).

Now, most lenders will assess a 5 year interest only term over a 25 year loan period instead of 30. For a $500k loan, this increases the assessed repayment by a little over $200 p/m, having about a $33,000 impact on your borrowing power.

7. Having ANY HELP debt on a median income will reduce your borrowing power by ~$60,000.

HELP repayments are based on a sliding percentage depending on your income. On an $80,000 income, 6% of your income is withheld to repay this loan. That means an additional expense of $400 p/m. This reduces your borrowing by around $60,000.

Therefore for some at the edge of servicing that have a small HELP debt, it may make sense to repay this loan. Repayments are based on income, not loan balance/size.

8. Obtaining a novated car lease for a $20,000 vehicle that includes all running expenses instead of a personal loan will reduce your servicing by ~$40,000-60,000.

Novated car leases usually include things like interest, fuel, car servicing, etc, into the monthly repayment amount, whereas personal loans usually have lower repayments because they only include the interest repayment. The other car costs can be included in the banks minimum living expenses for those that have personal loans. Therefore, Novated car leases do more damage as they potentially ‘double dip’ the living expenses.

Note the impact on borrowing power varies significantly depending on the specific arrangements of the lease. I’ve used an online calculator that breaks down the novated car lease costs for a $20,000 car – the additional running costs other than finance equate to around $400 p/m. This varies depending on finance terms, km’s driven (fuel cost impact), etc.

9. Deciding to buy a $500,000 property (100% financed) to live in vs rent @ $500 p/w will reduce your borrowing power by approximately ~$180,000.

The assessed expense for a $500,000 owner occupier mortgage debt is around $3.4k p/m (despite only paying $1.75k p/m in interest). If instead, that someone rented the same place at $500 per week ($2,166 p/m), lenders will take it exactly at $500 p/w in servicing assessment. No loading applied for rental expenses.

In this scenario, that’s a whopping ~$1,250 difference in your monthly expenses. Therefore, under some lender calculators, you’ll be able to borrow $180,000+ more for investments by making the choice to rent instead of buy in this scenario.

These aren't anything but quick guidelines, if you want more specific responses your best talking to your broker. The actual amounts will vary from the above depending on the range of factors I've mentioned (and others) above.

Cheers,
Redom

 

And a chart of it all for those that prefer visuals.

Borrowing Power by Redom posted 7th Mar, 2016 at 10:16 PM

 

Great summary Redom

 

Great post @Redom

 

Great post!

 

Great post redom!

Question on point no. 9 (mortgage vs rent): do you mean that by indicating you're buying an investment property and you'll will be renting that property out will help serviceability? But wouldn't IP rate generally be higher than PPOR loan (especially of recent APRA change) and hence worse serviceability compared to a PPOR loan?

Thanks again redom. You're a champ.

 

Great post!

Now all we need is a web-based tool ( or a spreadsheet ) where we can run scenarios for ourselves ...

 

Yes but I think the net gain still puts you ahead to rent where you want and invest where the numbers stack up.

 

Excellent summary Redom!

It helps a lot. If you rent personally for $500/wk, that rental payment is not loaded at all, where the mortgage payment if you live in your PPOR is not only loaded, but assessed at P&I payments even if you pay IO (with most lenders).

 

Hi febstyle,

Yes renting for those amounts vs buying (at 100% finance) will assist quite a lot for serviceability purposes. That doesn't mean you should do that of course - your own home can also be viewed as an appreciating asset, so it can be viewed as building up the portfolio and can make a very big difference to wealth creation.

A separate question altogether is the difference between having investment debt vs PPOR debt (your second point). It is relatively marginal in borrowing power calcs (excluding the additional income). Investment debt generally has negative gearing addbacks, but is more likely to have slightly higher assessment rates.

 

Sorry @wombat777 there's no simple spreadsheet that will give you more than a general answer which no lender will accept. I can give you the spreadsheet for several individual lenders but you'd probably fill in the numbers incorrectly anyway. Brokers pay a lot of money for software that helps them figure this stuff out and I'm yet to find a package that is consistantly accurate.

It needs to be stressed that this post isn't going to tell anyone what their borrowing capacity is. Redom has pointed out a lot of elements that contribute to borrowing capacity, but each lender has a variety of policies that contribute to these outcomes in varying ways.

For example item 3, where a $10k credit card reduces your borrowing power by about $35k. For some lenders it might be about $25k, whilst others it will be closer to $40k.

Item 6 an I/O loan will reduce your borrowing capacity which is true for most lenders. There are a few however that an I/O loan will actually increase your borrowing capacity because of the way they assess existing debts.

@Redom has published some fantastic information. It can help you make some financial decisions. Do you pay off the personal loan or the HECS debt? Do I want my own home enough or is it okay to keep renting? Should you save for a new car or take a lease?

You still need to understand what your borrowing capacity is and how this fits with your goals, both immedate and longer term. To assess that, you're going to need professional advice.

 

@Peter_Tersteeg , I was not trying to suggest that such a tool would replace professional advice. It would merely be helpful for running basic what-if scenarios about how other finance arrangements or changes in personal circumstances would 'typically' impact serviceability in basic situations. Such a tool on a broker's website might help a potential or current borrowing client think twice before committing to other finance agreements or take positive steps to make changes that will improve their serviceability.

 

If you were to pass a lender calculator with $1 surplus would they approve if everything else stacked up? Or do they require a buffer on your surplus?

 

It depends on the lender - some will require a 5% buffer, others will literally accept 1 cent in servicing. I've pushed a few through which have been <$5 positive servicing which is fun when the interpretation of income, liabilities etc can be rather variable.

 

Thanks all, glad this is of some use. Definitely, this post is very general and gives a guideline to readers about how things work - it definitely cannot replace individualised professional advice. There is much variation and subtlety to it all, with a range of factors (noted in the post) impacting how different scenarios will play out.

@albanga - depends on the lender and the type of deal. If its already high risk, income is varying, it can cause big issues just scrapping by on servicing with some lenders. Some like to see at least $100 positive (NAB) and apply more of a common sense approach. E.g. assessor rings back and says its really tight, could we make this minor adjustment, e.g. drop CC by 5k to make it work. I've had deals where the last dollar is dragged out (CBA).

 

are dual income places such as house and granny flat summed and treated as one? ie if i add a granny flat that yields 14% but net property yield is still 6%..then they take into account the lot?

 

Brilliant!!

 

Also interested about this

 

This is a great post. Thanks for taking out your time to write it up.

Is there any impact if income comes into a discretionary trust, then distributed to family members?

 

You're asking if they take into account the rental income from the primary house as well as the granny flat? No problem; assuming the income can be proven in the normal way (lease agreement, bank deposits, property managers statement).

Depends a little on the circumstances of how the trust makes money, but as long as it's evidenced via tax returns and is consistent over a few years, generally trust distributions are fine.