A complicated formula that shows lenders your borrowing power.
For those of you who are looking to apply for a mortgage loan, it helps to have a general idea as to how lenders calculate your borrowing capacity. That way, you can get yourself in the best financial position to obtain a home loan with the best rate for your needs.
The borrowing capacity formula
Lenders generally follow a basic formula to calculate your borrowing capacity:
Gross income - (tax - living expenses - existing commitments - new commitments - buffer) = monthly surplus
While lenders all adopt this general framework, there are differences in how they weigh and assess each dataset outlined below.
Lenders calculate gross income from multiple sources. However, depending on the consistency of your income, lenders may decide to assess a reduced amount.
- Base income: All lenders take base income in-full in their assessment because it’s considered consistent and relatively stable when compared to other sources of income.
- Overtime: In most cases, lenders only accept 50% of overtime payments as part of their calculations because overtime work is often considered casual in nature. However, for roles where overtime work is regular and ongoing, such as firefighting and emergency services, lenders can accept 100%.
- Bonuses: Lenders are unlikely to accept bonuses at 100% because they aren’t consistent. Where they are regular, you need to produce a two-year statement to prove this.
- Commission: Lenders may accept 100% commission as long as it’s consistent and ongoing, and similar to bonuses, need you to produce a 1 to 2 year history showing this.
- Family Tax Benefits A and B: Lenders will accept Family Tax Benefits as part of your gross income if your child is under 11-years old. Other tax-free income is assessed case by case.
- Rent Income: If you have investment properties that have rental income, only about 75 to 80% of the income will count towards your assessment. This rate takes into account costs associated with owning a rental property such as maintenance, management, and rental vacancy.
Each lender weighs up your tax expenses differently. For example, if you have an investment property that is negatively geared, some lenders will take into account the tax benefits of this property, whereas others won’t. Be sure to check with your prospective lender about their requirements for tax expenses.
Lenders generally use the Household Expenditure Measure to estimate your living expenses. This takes into account your family size, location of your home and your lifestyle. If you have children, expenses are usually assessed a little higher for your first child.
Borrowers who apply for a mortgage separately from their partner also have their spouse’s expenses assessed. However, some lenders leave out these expenses where the spouse is also receiving income.
New and Existing Commitments
If you have any existing debts, these are also factored-in by your lender. This could include Higher Education debts, car loans, and other existing mortgages to name a few. When it comes to existing mortgages, lenders may either choose to use the actual repayments or use a higher assessment rate to calculate your borrowing capacity.
For credit cards, banks will calculate a 2 to 3% minimum monthly repayment obligation of the approved credit limit. This applies even if the balance on your credit card is nil. This acts as a safeguard for your lender because that credit can be used to its limit at any time.
If you’re looking to apply for a mortgage, it’s a good idea to reduce your credit limit as much as possible and cancel any credit cards you don’t use.
On top of all this, lenders also consider your ability to pay back your loan if the interest rate were to rise. In their assessment, lenders add a margin of about 2.5% to the variable rate. They also assess your repayments as if it were a principal and interest loan even if in reality, the loan is interest-only.
The methods for displaying your borrowing power
Having taken into account the borrowing capacity formula, lenders have different methods of displaying your borrowing power. There are quite a few ways to do this but most lenders use the following three methods.
Method #1: Net Surplus Ratio (NSR)
This method is calculated as: (After-tax monthly income - monthly living expenses)/Total Monthly Commitments.
Typically a 1:1 ratio is the minimum for eligibility, anything under (such as 1:0.9) will not meet the requirements.
Method #2:Debt Servicing Ratio (DSR)
This method is a debt service measure lenders use to determine what proportion of a household income is used to service debts. Lenders aren’t willing to grant loans where the DSR is too high.
Method #3: Uncommitted Monthly Income (UMI)
This method uses the total income left over after deducting all the relevant expenses and commitments.