Projecting serviceability

Hi,

I have set up a projection that projects future cashflows allowing for income, expenses, and the net cashflows from properties, as well as assets and liabilities. This allows me to project when I'll have sufficient savings/equity to purchase an additional investment property. It's my understanding that I can't keep buying, saving/building equity, buying, over and over again. At some point in the future, even though I have a sufficient deposit, I won't be able to purchase another one due to serviceability.

So how would I allow for serviceability? As an approximation, would I have to change interest rates to 6 or 7% when I want to purchase that new property and see what the net cashflows are. As long as the net cashflows are still positive at this higher interest rate, then it is within my serviceability? It's more complicated than this in reality, but would this give me a reasonably good approximation?

 

it will be difficult to factor in, but you could ball park it at 6 times annual income pretax as the total amount of debt you could hold.

 

Your best bet is to get a broker to see what maximum you're capable of now, using an average rental yield for future purchases.

That will give you a ball-park with a major lender, and once that pot of money is used up you can restructure and look at the more generous non-banks if your risk appetite allows.

In reality, what your actual expenses/ cash-flows are and what the bank will allow for are completely different things.

 

For servicing purposes, use a rate of 2.5% higher than the actual variable rate you're paying. Calculate the repayment on a P&I basis over the remaining P&I loan term.

You also need to factor in other debts. Credit cards are about 3.5% of the limit each month. Personal loans at actual repayments.

Living expenses is a tricky one because it varies based on location, income and family structure. As a rule of thumb, figure out what you think you spend (without actually looking), double it and you'll get close to the banks figure.

If you actually want to know what your borrowing capacity is across different lenders, you need to consult a broker.

 

Get a big pay rise. Win lotto. Inherit money .... or pay down debt .

In reality you need rental yields of over 10% to even be close to neutral on a lender servicing calc Lenders take between 70% and 80% of rental income, so a 10% yield is deemed to be 7% or 8%. by lenders. And even if you get those yields - which you won't - lenders generally wont accept more than 6% anyway. Some may, but its a moot point as you wont get 10% anyway. So that's problem # 1. There is no way to generate enough yield to never hit a servicing wall.

Problem #2, which compounds problem #1, is how investment debt that you already have is treated versus how it used to be treated. We live with sensitised P&I assessment rates nowadays. Loans are assessed with a 2.5% buffer above the rate you are actually paying , and at P&I remaining term. It means that IO lending , while attractive for tax purposes and attractive on a spreadsheet- is cryptonite to portfolio building . C R Y P T O N I T E with every letter a capital. P&I is the way to go - even though it is contrary to every piece of tax advice , investment advice or get rich from property advice anyone will ever give you

Let me demonstrate exactly why IO lending is cryptonite to your borrowing capacity using an example of a 500K loan at a 3% interest rate, where you take P&I from Day 1. In this ( and any other example you want to look at ) a lender will "deem" the debt to be costing you 5.5% P&I over 30 years. Not 3% . That means that it's costing your pocket $2109 per month but the lenders calculator deems it to be costing you $2839 per month . That's $730 per month extra. Or $8760 extra per annum. Your spreadsheets and hip pocket dont feel it. Your borrowing capacity certainly will.

If you took that loan with 5 years IO, a lender will "deem" that to be costing you 5.5% P&I over 25 remaining years. So it would be costing your pocket $1250 per month but the calculator will deem it to be costing you $3071 per month. That's $1821 extra per month, or $21,852 per year. Again, while the loan is IO your spreadsheets and hip pocket dont feel this, but your borrowing capacity certainly will.... and if you are unable to extend or refinance the IO term at the end of 5 years, your hip pocket will feel it then too when the loan reverts to P&I and your repayments go from $1250 to $3071 per month... and NONE of the extra $1821 is deductible . None of it.


The other issues around living expenses being increased significantly over recent years are problem #3 and as such they are also a part of the wider borrowing capacity problem, but their impact isn't as significant as the impact each IO loan creates. The more IO you carry, and the longer you carry it , the more lender calculators punish you... Its really that simple.

Which brings us full circle to .... If you want to buy, and then hold, and then build /add to your portfolio.....

Get a big pay rise ( and as the numbers above demonstrate, 5,10 or 15K isnt going to get it done if you want to get past a modest number of properties using modest levels of debt ...I mean a BIG pay rise) or win lotto and pay down debt ... or inherit money and pay down debt ... or do the only other thing you can really totally control - buy properties that help you pay down debt .

But remember - buying properties that offer strong yield isn't about improving serviceability right way. As outlined above, strong yields are generally capped at 6% by lenders , so the yields aren't a silver bullet that cures all your problems right away.... where strong yields offer their real value is when you reinvest the surpluses towards debt reduction. That rewards you over time so that you can eventually get past servicing ceilings , harvest your equity and grow/add to your portfolio ....

I should also note these are extreme examples. Most people can use IO and still do fine... let's be honest, even when these post APRA rules weren't around, only a very small % of investors went anywhere near their ceilings... the reality is that not many investors ever get past 1 or 2 properties. Where this sort thinking really matters is for those who want to go seriously, seriously seriously about things... large portfolio's. Not just a large number of properties, but also a large amount of debt. For those types, they need to look at all the ramifications of carrying lots of IO debt.. and you know, it's not just about borrowing capacity... its equally about holding costs. There are plenty on here who can tell you how uncomfortable it became for them back in 16/17/18 and last year as their loans rolled out of IO terms.... fortunately most of them avoided the P&I cliff because the RBA cut rates to record lows, but that last trick in the bag of tricks is now exhausted.... no tricks left.... so the next P&I cliff wont be avoided so easily.

To build and hold and grow a portfolio, you have to not just borrow enough money, you need to be able to meet repayments under P&I terms. maybe not right away...but it comes a calling for everyone eventually. Bottomless cups of IO aren't being served any more.

 

So this is what I've heard. You're capped at around 6-7x, but it doesn't make sense to me. I've got pre-approval for a loan which would put me above this. And then I wouldn't be able to buy another investment property unless I pay down the debt significantly or get large pay rises?

Yep so I've got pre-approval for how much I can borrow right now. I'm more curious about how I will buy IPs 4 or 5 and whether I'll get stuck.

I agree on the expenses point. I hear the bank uses some minimum amount anyway. So even if you provide them with what your current expenses are, if it's less than what that minimum, they'll take their number and use that.

Wow double expenses. I didn't realise they bump it up by that much for serviceability.

I already know what my current borrowing capacity is. As I said above, I'm interested about whether I'll have the borrowing capacity when I'm trying to purchase IPs 4 and 5.

Thanks for all the detail!

I didn't know IO loans were significantly worse for serviceability.

So even with high salaries (ie if my partner and I were collectively earning 500k pre tax collectively), does this make it impossible to amass a significant property portfolio (Eg 5m+) by just buying and holding?

 

It would depend on all sorts of things... what I have outlined is how lender calcs treat IO debt v P&I debt for servicing purposes...

if you are earning 500K , you can certainly borrow more than many.... but even so, if or when you exhaust your particular limits/ceilings, you will find you have the same conundrum all borrowers do when they reach their particular limits/ ceilings..... see above

 

If you are just after a quick ball park figure there is not much you can do other than to assume 6 to 8x annual income. If you want to incorporate more accurate serviceability calculations each lender has a different way of working it out so you would have to choose one and try to get a hold of their calculator and try to incorporate this somehow. Would be complex.

 

Not if you structure things properly...

In fact...P&I loans are CRYPTONITE if you want to grow your portfolio bigger than about 3 properties for the average investor - in the near term.

Everything has it's place at the right time for the right investor. It's not one size fits all...I understand you've got your pet strategy, but paying P&I is not the only way to reduce debt and expand borrowing capacity.

 

The banks don't double people's expenses, they have standard table that gives minimum figures indexed to income, location and family structure. These tables are not available to the public. It's made more difficult because the figure used for the 'income' component can vary from one lender to another depending on their policies.

It's my general observation that about 70% of people spend about double what they think they spend if they don't check their statements.

 

Did I say it was the only way? I'm pretty sure I mentioned FOUR ways.... yep. 1,2,3...4

What I did say though, is that carrying IO debt produces a lower maximum borrowing capacity when compared to foregoing IO - on most lender calcs. If you disagree - let's see the numbers

 

If we’re talking accuracy....Only dangerous if your Superman . Sorry couldn’t resist... nothing to see here... back on topic

 

Can I confirm that PPORs would be treated the same as IPs in assessing serviceability? ie if I had a 2m PPOR with 1.6m of debt vs 2m IP with 1.6m of debt. Obviously the net cash flows are different, but in terms of looking at the debt/income ratio limit, do they both have the same impact?

 

No, because you can apply negative gearing to the investment debt in lender servicing calcs, can't do that with the PPR debt

 

Makes sense.

Does rental income on existing IPs count to my income for the rough guide of 6-8x income?

 

and of course, INV properties are income producing as well. PPOR's are not

 

Yes. But remember, lenders don't accept 100% of rental income.

You can ask question after question, but you will keep being told the same things There is a cap to what you can borrow. It isn't a precise , one size fits all cap, but it will almost certainly sit in the 6,7,8 x income range... Yes, there is some variation between lenders of course, but ultimately , your max capacity will still sit somewhere in or around that "range" just about everywhere...... except for a couple of lenders like Liberty or Bluestone , under some circumstances... but even at those lenders there are exposure limits so you can only use them to a point ... they wont let you borrow and borrow and borrow.... and they also charge premiums for using IO lending and for having more than 3 properties in total.

There is no escaping what I outlined in earlier comments if you want to buy multiple properties...as in 6,7,8 etc..or more. and hold them long term.... and continue to add properties without needing to sell..... unless you are on mega bucks and don't go anywhere near your ceilings , even with many many properties and many millions in debt .... but if you are in that sort of position you don't really need to be concerned about anything other than getting on with it ..... inconveniences like paying down debt, servicing ceilings etc... they are only issues for the other 97%

 

Haha I was asking a different thing. Because originally I was thinking that 6-8x income maximum for debt was just on our salaries. So in my projection I got stuck a bit earlier than I thought I would. Maybe I should also allow for like 80% of the rent in that ratio too. I know it’s not perfect but I’m using it to help with some long term strategy planning.

That all makes sense though. Is it better for serviceability to use multiple lenders instead of all loans with the same lender? I know it might not help heaps, but even a bit? And yes I know you’re going to say it again, that you just need to get higher income.

 

I had similar questions in my mind, as I have also recently started my property journey. After talking to mortgage brokers, buyers agents, investors who have like 10 properties etc., this is what I have understood.

1. Most of them accumulated properties before APRA tightening, when actuals were being used.
2. It is a futile exercise to keep worrying about serviceability from day 1, because in the past 12 months alone, lending standards have changed several times. So even if you put in a lot of effort and come up with a theoritical serviceability threshold, lending rules may change next week and your estimate may no longer be accurate. It changes with interest rate, income, rents you can get, floor rate etc.