Borrowing Power and Purchasing Power: What you need to know before house hunting

You wouldn’t shop for groceries without knowing how much you had in your wallet or bank account, so why would you shop for a property without knowing your numbers? There are two main concepts that you need to understand before looking for a home or investment property; Your borrowing power and your purchase power.

Your borrowing power, also called your borrowing capacity or serviceability, is a calculation of your ability to make repayments on a loan. Your borrowing power is then added to your savings or equity to calculate your purchase power, i.e. what is the actual maximum price you can purchase a property.

In its simplest form, your borrowing power is calculated by deducting your expenses from your income. The remaining income is then used to cover repayments. However, there are many variables built into the equation that vary between lenders.

Responsible lending guidelines suggest lenders add a 3% buffer to their actual interest rate. We call this an ‘assessment rate’. The assessment rate is used to ensure there is a healthy buffer built into the borrowing power to cover any rising interest rates or changes to your financial circumstances. Lower interest rates may be available for loans with a lower loan-to-value ratio (LVR), and higher interest rates may apply to higher risk loans like those with high LVR or borrowers with poor credit history. Different loan products can also have different rates, such as basic variable, offset loans, or fixed loans.

Each lender may consider different types of income differently. Most lenders will take 100% of your standard hours for your PAYG job. Some will only take 80% of casual income, overtime, or second jobs. Uncertain incomes like short-stay rental may be 50%. And not all lenders will consider income from Centrelink, or short contract employment.

Your expenses include any repayments on existing loans, like car loans and personal loans. It includes repayments on credit cards, and assumes they are fully drawn to their limit despite your actual balance. It also includes your monthly living expenses across a broad range of categories. It is important to estimate your living expenses as accurately as possible to ensure that you’re not missing any essential expenses, and that you allow for expenses that you will incur on a new purchase (e.g. Water and Land Rates, insurance). If you estimate your expenses are lower than the minimum Household Expenditure Measure (HEM – a statistical average) then the lender will adopt the higher of HEM or your estimate.

As you can see, the simple equation of income minus expenses quickly becomes complicated. This is where a Broker’s expertise comes into play.

Now we have your borrowing power, we can calculate your purchasing power! Sometimes as easy as adding your borrowing power to your savings contribution. Sometimes much more complicated.

Your purchasing power will be limited by either your borrowing power, your savings contribution (or equity), or lender policy. As a general rule, the most you can borrow is 95% of a property’s value.

We need to allow for expenses that are applicable to your circumstances, such as stamp duty and government transfer fees which differ from state to state. Other fees like conveyancing, pest and building, and rates adjustments also need to be considered. If you are paying Lender’s Mortgage Insurance (LMI) this can be a significant cost that can be added to the loan, but will affect your purchasing power.

Here’s an example;

You have a borrowing capacity of $500,000 and $100,000 in savings – this doesn’t mean you can buy a house for $600,000. Firstly, we need to deduct stamp duty and fees from your savings, and then consider the overall LVR and LMI. If you’re not eligible for any schemes or concessions, this could reduce your purchasing power to $575,000.

Keep in mind that different property types can attract different LVRs. For example a small studio apartment in a high density, or a 50ha rural property, could both be limited to lower LVRs than a standard residential block.

The best time to speak with your Broker about your Borrowing Power and Purchasing Power is up to 12 months prior to your intention to buy. This might seem like a long way off, but the insights that you can learn from this exercise will help guide your budget and savings goals, as well as set up realistic property expectations.