Borrowing Capacity vs Serviceability - Test Yourself With These and More Finance Tips
Have you ever found yourself in a situation where you have applied for a loan, but it gets rejected? The reason could be due to the bank's evaluation process.
Many borrowers are unaware that the bank considers not just the borrowing capacity of the loan but also its serviceability.
Borrowing capacity - how much you can borrow at that instant in time (mainly determined by your capital - ie savings and equity).
Serviceability - how much loan you can service (determined by your income and expenses).
Sometimes these numbers are similar and other times they can be greatly different! For instance you could be able to service much more debt than your pre approval however your available deposit is the limiting factor.
In this post, we will explain the difference between borrowing capacity and serviceability and how the bank calculates both to help you increase your chances of getting your finance approved.
How Do Banks Assess Your Borrowing Power?
Banks will look at your income, expenses and rental return from the property to determine how much you can borrow.
A general rule is that you can borrow around six times your income, but not all forms of income are treated equally by lenders.
Lenders usually perceive the income of self-employed, casual, or contract workers as being less secure compared to full-time employees.
However, some banks will allow full income to be used from self-employed companies plus their associated add-backs, and some banks will even work from one year’s worth of financials.
Most lenders will load up your expenses using a minimum benchmark. Even if you live with your parents rent-free, they will still use their minimum expense. So, examine your regular expenditures and eliminate non-essential luxuries such as daily bought lunches or coffee.
Credit card debt or lines of credit can greatly impact your borrowing ability, so it's best to close credit cards or decrease their limits. Even with a $0 balance, the bank considers you to owe the full amount to minimise their risk.
You can also avoid taking out personal or car loans, as these debts will negatively affect your credit rating and how much debt you're currently repaying.
It’s well worth finding a good broker who can help you prepare or structure your finances before submission or at least identify ways within your finance submission to condition the closure of cards or lines of credit if it helps your application.
The Impact of Risk Ratings
You may not be approved for a loan if the risk rating is too high for the bank. There are also a few other factors to keep in mind that the bank will assess to approve your loan:
Location: Is the property situated on a busy road or beside a noisy facility (such as a train station or factory)?
Land: Is it usable and appealing as a site? Is topography or drainage a challenge?
Environmental issues: Is it in a flood zone, or are there fire hazards?
Value: Is it in an area where banks expect to drop in value over the next two or three years?
Square metreage: Smaller properties, such as apartments under a certain size, can be considered high-risk.
How Do Banks Calculate Your Borrowing Capacity?
There are two important borrowing calculations to be aware of:
Debt service ratio: This is the ratio of your loan repayments to your gross income. For most lenders, this figure should not exceed 30 per cent for singles and 40 per cent for couples.
Net debt to income ratio: This is the ratio of your net disposable income to total debt commitments. For most lenders, this ratio must be greater than 1.25:1 – that is, your net disposable income needs to be at least 25 per cent higher than your total debt commitments.
What Can You Do to Boost Your Borrowing Power?
There are two ways you can borrow more: increase your cash flow or reduce your outgoings.
Boost cash flow by seeking pay raises or getting a second stable job, raising the rent on current properties, or acquiring higher-yielding properties.
On the other hand, lower your expenses by limiting lifestyle costs and eliminating liabilities such as credit cards.
The vast majority of lenders will prefer you to pay principal and interest (P&I) on all your loans, as the banks will most often service your debts over a 30-year term.
A good broker will arrange your borrowing options from the most difficult to obtain to the easiest (often non-bank lenders).
Pre-approval indicates that your finances are organised but do not guarantee a loan amount, and the bank must assess the property as a secure investment for approval.
Pre-approval also enables you and the seller to estimate what you can afford and provides you with the maximum available funds, allowing you to confidently target your search and negotiate.
However, excessive pre-approvals in a short period can harm your borrowing capacity, as they show on your credit report as loan inquiries and may suggest financial instability. So, rather wait to apply for pre-approval until you’re certain of the lender you want to go with.
Key Takeaways
Making financial decisions can be hard - you want to get the best value for your money, but also make sure you're not sacrificing quality or serviceability.
Although it's very important to balance borrowing capacity and serviceability, we understand it's not always easy. But now that you have these finance tips in mind, you can test whether you're making the right decision for your needs and goals.
If you're interested in investing in residential property and would like to unpack more about what it entails, I’ve written this easy-to-read guide that provides a thorough overview of the process of investing in residential property.
“Residential Property Investing Explained Simply” covers a wide range of topics, from understanding the factors that can impact the value of a property to the ins and outs of property investment.
Alternatively, if you want to know how I’ve helped investors acquire a range of residential properties, feel free to reach out today.