Figuring out how much you can afford borrow is one of the first things first home buyers want to know. In the world of home loans, we call it your ‘borrowing power’. Once you’ve figured out your borrowing power, you’ll have an approximate idea of your price range when you start house hunting.
So how do home loan lenders work out your borrowing power? Generally, your borrowing power is your 'net income', minus 'expenses'.
- Your 'net income' is your after-tax income.
- Your ‘expenses’ are daily living costs, bills, plus any other debts you’re currently paying off. (Examples could include things like credit cards, car loans, personal loans.)
It sounds like a simple formula, but it can get complex when lenders consider things like the size of your family, or even the credit cards you may not be using.
The lending formula
Every lender’s formula for calculating borrowing power may be slightly different. Usually, they’ll take the following into consideration:
- your income, which can include bonuses, commissions and overtime
- the number of dependants in your family
- the secured and unsecured debts you hold (e.g. credit cards, personal loans or car loans)
- your living expenses.
Lenders tend to take a prudent approach to their calculations. For example, when it comes to credit cards, they may consider the limits on your cards – even if you don’t owe anything on them. So if you’ve got a credit card with a $20,000 limit, they may see that $20,000 as potential debt and then count the potential credit card repayments as an expense.
The lender also takes a similar approach when assessing your ability to make repayments. They'll factor in future interest rate rises and assess your ability to cope with the higher repayments that may be required.
Given all of this, it’s likely that different lenders will quote you a different maximum borrowing power. This is also why you may find that different online calculators can give you different results.
Looking beyond the formula
For example, let's say you're looking to buy a property and need a home loan of around $500,000 to purchase the property. If the lender approves this amount, you still need to ask yourself if you could comfortably afford the monthly home loan repayments (this would be $2,533 based on an example interest rate of 4.5% on a 30-year loan term with principal and interest repayments).
Also consider how you would cope if interest rates were to increase to 6.5%. This would mean your repayments would increase from $2,533 to $3,160 a month.
Have a think about your situation when working out how much you could borrow. You should be realistic about what you can afford today and in the coming years.
To work out how much you should borrow (as opposed to how much you can borrow) it could be good to go back to the basics and do a budget check. Look at your current lifestyle, track your spending, and see how much money you have left over each month. This may help you decide how much you could afford to put towards home loan repayments.
If you haven’t got kids yet – but they are on your radar – then this is something you need to consider. For example, in five years and two babies’ time when one of you may not be working – will you still be able to afford the home loan repayments?
While online calculators provide an indication of your borrowing power, they are an estimate only.
It could be a good idea to make an appointment with a lender to run through your financial situation, so you could get a more definitive answer. Then, you’ll be able to start house hunting with confidence.
Get a quick estimate on how much you could borrow
To sum up
- Generally speaking, your borrowing power is your net income, minus your expenses.
- Expenses can be affected by things like the number of dependents you have, or the amount of secured and unsecured debts you have.
- Think carefully about how much you can comfortably pay off a home loan each month, now and in the future.