Borrowing Capacity versus Affordability?
- By proadAccountId-384574
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- 04 Oct, 2017
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Just because the bank says you can borrow a certain amount doesn't mean you should!
Borrowing Capacity versus Affordability?
When it comes to borrowing money, many people confuse their borrowing capacity with their affordability. Just because the banks say you can borrow a certain amount doesn’t mean you should! Particularly with interest rates at such low levels.
When you borrow money, the bank or lender has a responsibility to ensure the loan is fit for purpose and will not cause financial hardship.
All lenders will assess your borrowing capacity on your current financial situation, as well as factor in a buffer in case interest rates were to rise. It’s a way of stress testing your capacity to service the debt now and into the future.
Borrowing Capacity
Even though interest rates are around 4% the banks will use a higher rate (3 to 4% higher) when calculating your borrowing capacity. The banks use the ‘assessment rate’ along with their other lending criteria, such as Household monthly expenditure (HEM) to determine how much you can borrow. Each lender has their own assessment rate and HEM, which is why your borrowing capacity can vary significantly from one lender to another.
Other factors banks will consider are your other loan commitments, your income including wages and rental income(s), they also include all your credit cards on the assumption that you have maxed out the limit (whether you have or not). Lenders also consider the number of financial dependants you have in your household, as this will impact your household expenditure.
Affordability
Your affordability is about you and your family’s lifestyle, choices and future plans. Are you going to start a family, buy a car, have children going to Uni ect. The choices you make and how you spend your money will differ to the person next to you, and therefore the cost of living that the bank uses to determine your borrowing capacity seldom matches your actual spending pattern. Your lifestyle is unique to you!
When you take on debt, you have a responsibility to you (and your family) to ensure that you are not going over your head and that you know your numbers.
As the saying goes, if you fail to plan, you plan to fail.
Before you take out a mortgage or any other type of debt, follow these simple rules:
1) Know your current cash flows (money in and money out). We can assist you with this and have templates which may help you (just ask us).
2) Work out your current disposable income BEFORE the new debt is factored in. Are there any planned or unplanned events that may impact your income?
3) Know what the new loan repayments will be and ensure there is adequate cash flow from your disposable household income that can easily meet the repayments.
4) Know the interest rate which the new loan repayments are based on, then calculate how much the repayments would increase by if your interest rate increased by 1%, then 2% and even 3%. Can you still afford to make the repayments from your disposable household income?
5) Is the debt you are taking on worth the time, effort & hassle and risk? What is it that you are financing? A holiday? A car? Or is it an asset that will appreciate in value over time and will in fact add to your wealth in the long run? (such as a property)
Don’t be overly conservative and have some faith. As there is no reward without risk! In the end, borrowing money is a key ingredient to creating wealth and owning a sound balance sheet for your retirement is important. Be smart about it and only take on debt which you know or expect to have the financial capacity to service now and into the future.
Borrowing money is not the issue, it’s paying it off is where some people run into trouble. Have a safe financial buffer to play with also as this is a great strategy particularly for investors.
When it’s all said and done, it boils down to this. Serviceability is the bank’s responsibility and Affordability is yours. Get help to choose the right Home loan
So you’ve found your dream home, but it’s in need of a little TLC. While others may see this as a deterrent, this is actually a great opportunity to nab the house of your dreams at a price tag that’s within your means. Here’s how to tactfully negotiate the price without ruining your chances of securing the property.
Tip #1: Never Enter a Negotiation Empty - Handed
Whether it’s hiring inspectors for a building and pest report, or obtaining quotes from tradespeople, obtaining facts and figures will give you ammunition when requesting a price reduction.
“Even if it costs you extra, it’s worth getting all the information before making your offer. People often underestimate how much repairs will cost,” says a real estate agent.
Tip #2: Separate Your Emotions
The most tactful way to negotiate is to eliminate all emotions, advises the agent. “Try to separate yourself from the outcome and present your side logically. The owner is under no obligation to accept what you offer, no matter how well you present your points . So if things don’t go your way, being negative won’t do you any favours.”
Tip #3: Remember This Is Someone Else’s House
Negotiation is a two - way street, so in order to come to an agreement, concessions will have to be made on both sides. “Try to understand what is important to the owner,” advises the agent. “What can you offer to counteract the price reduction you’re after? Perhaps a longer settlement period so they can find a new home? It’s little enticements like this that can often be much more valuable than a couple of extra dollars.”
Tip #4: If You Don’t Ask, the Answer Is Always Going to Be No
“I’ve heard a lot of weird and wonderful requests when it comes to purchasing a house, so really you can ask for anything. Whether or not it will be accepted is another thing,” advises the agent.
From wanting certain fixtures included in the sale price, to extra inspection requests, you won’t know what the owners are happy to give if you don’t voice your desires. However, before you go wild with request s, think about what is most important to you, as realistically the owners aren’t likely to budge on everything.
“In theory, you can inspect a property as many times as you like. In practice though, it will depend on your agent’s availability and whether or not the owner is currently living in the property,” says the agent. “You might put off the owner if you are constantly disrupting their day, so as an alternative I’d suggest visiting the street at different times during the week. You don’t have to enter the actual home to get a vibe of what the neighbourhood is like.”
A house that requires a bit of repair work is a great bargaining tool and generally an opportunity to secure a good price. With the advice of industry professionals, securing your dream home may be closer to a reality than you think.
The last 12 months have seen a lot of changes particularly in the interest only lending scenarios. And mortgage brokers and borrowers have had to adapt to the new landscape. We certainly didn’t foresee the rate rises in interest only loans of .25% to .5% and the likehood is that in the near future this gap could increase!
APRA is driving this change!
Most of the banks have made changes to their interest only policy and pricing because of limits put in place by APRA. Naturally we don’t like having our options limited, or any added complexity to choosing the right loan, however it’s important to review & adapt your lending strategy to this new landscape.
The drivers for APRA to these changes are:
· Australia is addicted to interest only loans, this is a risk for both the banks and our housing market.
· Few borrowers are aware just how much more interest they’ll pay with an interest only loan.
· There are many people making interest only repayments even though it’s totally unsuitable for them.
In other words, it’s time to adapt your current lending strategy, rather than complain about higher interest only loans.
Great questions lead to great recommendations
At Focus Loan Choices we get to know our customers by conducting a personalised needs analysis. We identify what’s important and weather an interest only loan is suitable by asking what’s more important for you:
· A lower rate or lower repayments?
· Higher borrowing power or a lower rate?
· Do you need to reduce your repayments in the short term?
If a lower rate or a higher borrowing power is more important to a customer, then they should probably be paying P&I.
Owner occupied loans with interest only repayments
As a general rule, this is an unsuitable option for most clients and you should only consider this if there’s a good reason to do so.
Usually this type of scenario is unlikely to benefit from interest only repayments and potentially, they may not pay off their home loan at all.
It’s time to talk to non-conforming lenders
At Focus Loan Choices , we consider investment loans to be a type of non-conforming loan. That’s not to say that banks don’t do them. They’re just not the flavour of the month and you need to consider specialist lenders as well as major ones to meet the needs of property investors.
What do the numbers say?
As an example if your deciding between a $500,000 investment loan at 4.5% over 30 years, or a loan at 5% for 5 years with interest only payments reverting to 25 years at 4.5% with P&I repayments.
Firstly the repayments are $2,533 / month P&I compared to $2,083 / month interest only. So the payments are 21% higher if they pay P&I. At the end of the interest only period the repayments would be $2,779 which is 9% higher than the standard P&I repayments over 30 years. Few customers are aware of this and even fewer consider the effect that this will have on their cash-flow.
Paying P&I, the customer would make total payments of $912,034 whereas, with a 5 year interest only period they’d pay $958,749. That’s a whopping $46,715 in additional interest! Again few customers are aware of just how much more it will cost them.
A good rule of thumb is that a 5 year interest only period will cost a customer 11% more in interest over the term. That’s assuming, of course, that they don’t get another interest only period when their first one expires.
What about borrowing power? If a single borrower with an income of $100,000 takes out a home loan, then they can borrow around $620,000 with P&I repayments or $585,000 with a 5 year interest only period. It’s not a huge deal, only a 6% difference. For customers with multiple properties, it can have a much bigger effect.
What about your existing Lending?
Should you refinance to the cheapest interest only loan available if they’re not happy with their bank? Probably not. Variable rates can be changed at any time, so what’s to stop the new bank putting their rates up?
However, it’s now time to switch to P&I. I encourage all investors to review theircurrent lending and consider either switching to a P&I loan, refinancing to another lender with P&I payments, or if they do want to pay interest only, then fixing their rate may be a good idea.
Need help or require further information then contact your local MFAA accredited Finance Broker Rod Donnelly on 0437 776623.
Published by MFAA
Refinancing your assets to renovate a property is a significant decision that will hopefully improve your standard of living or add substantial value to your property.
Refinancing isn’t as straightforward as you might expect. The type of renovation proposed goes a long way to dictating the loan required. If the wrong loan is chosen, you could be left with a pile of unexpected debt.
Know your budget
Before considering refinancing, you need to have a clear idea of your budget.
If you underestimate your budget, you run the risk of getting knocked back from your lender, according to Rod Donnelly an MFAA accredited Finance Broker.
“I know a lot of homeowners who have estimated a budget of say $100,000 to do renovations, only to discover it will cost a lot more,” the broker says.
“This means you may have to reapply for the loan, which banks generally don’t like.”
“Be conservative with your projection. If you think you need $100,000, I’d recommend to apply for $150,000 just in case, if you can afford it. The key is stick to your budget,” adds the broker.
The next step is to speak to your broker to determine which loan will suit your needs and objectives.
Line of credit loan (Home equity loan)
Also known as an equity loan, to be eligible, one must be looking to make upgrades to the cosmetic domain of their property.
Installing a new bathroom or kitchen, painting the interior or exterior of the house and other basic construction falls under a line of credit loan.
These renovations, more often than not, do not supersede the costs of structural changes, so homeowners can call on up to 80 per cent of their Loan-to-Value Ratio (LVR).
A line of credit loan is a “revolving door” of credit that combines your home loan, daily spending and savings into one loan.
To calculate the value you can borrow, subtract your current loan balance from your property value and then multiply by 80 per cent. For example, if your property is worth $500,000, and you have $250,000 left on your loan, your home equity is $250,000. You then multiply this total by 80 per cent. If you’re uncertain of your home value, contact an Rod Donnelly a Finance Broker who can assist you to arrange for an appraisal or valuation. For Loan calculators, click Here.
If you choose a line of credit home loan, it essentially works as a large credit card. You can use it to purchase cars, cosmetic renovations and other investments. However, the interest-only charge starts when the equity is drawn down.
Keep in mind, line of credit loans provide you with money that can gather interest quickly, so if you are ill disciplined with budgets or money, speak to Rod Donnelly from Focus Loan Choices for a plan that matches your unique circumstances.
Construction loans
Construction loans are suitable for structural work in your home, for example, if you’re adding a new room or making changes to the roof.
Construction loans give homeowners the opportunity to access larger sums of money, with the amount dependent upon the expected value of the property after renovations are completed.
The advantage of a construction loan is that the interest is calculated on the outstanding amount, not the maximum amount borrowed. This means you have more money available in your kitty, but only pay interest on the money you choose to spend. For this reason, the broker may recommend that you apply for just one loan, but leave some leeway in your borrowed kitty.
When applying for a construction loan, council approval and a fixed price-building contract are required, which an MFAA finance broker can assist with to reduce the paperwork and stress.
Your lender will appoint an assessor to value your construction at each stage of the renovation. This will happen before you pay your instalment. When construction is complete, speak to your mortgage broker as you may be able to refinance back to the loan of your choice.
When looking at both these loans, the broker says consumers can call on other property they own to boost their overall borrowing amount if they wish.
“Depending on the client, they can use other property to get a line of credit and a construction loan. Or they might get a typical construction loan if there is going to be an extensive framework change on the building,” the broker says.
Broker advice
If you speak to a broker they will be able to determine which loan will give you the options you seek. This advice is essential, as a poorly planned construction loan could cost you more down the road.
“Consumers should ask their broker, ‘What type of loan am I eligible for?’, because if you don’t get your construction loan right, you may be jeopardising your bank security,” the broker says.
While these specific options can be discussed with your broker, if they aren’t suitable, there may be other options available to you. Speak to an MFAA Accredited Finance Broker to make your grand renovation plans a reality.
