How do lenders calculate your living expenses when assessing your home loan application?
When you apply for a home loan, the lender will assess a range of factors to determine whether or not you can afford to repay the money you borrow. One of the factors the lender will take into account is your living expenses, including the amount you spend on your groceries, utilities and entertainment.
However, there are different methods lenders use to calculate your living expenses, and your ongoing costs will also be influenced by the size of your family and the number of dependants you have. With this in mind, it’s important to understand how your living expenses can affect your borrowing capacity.
Why are living expenses important?
Under the National Consumer Credit Protection Act, lenders must make an allowance for living costs when deciding how much an applicant can afford to borrow. The money you pay towards groceries, fuel, clothes for your kids and a range of other expenses will all eat into your weekly budget, and will have an impact on the amount you can afford to spend on mortgage repayments each week.
For example, a young couple with no children will most likely have fewer expenses than a family of five. Similarly, a young single with an active social life will probably spend more each week than a pensioner who no longer drives and has few outings.
How are living expenses calculated?
There are two main methods that Australian lenders use to calculate the living expenses of mortgage applicants: the Household Expenditure Measure (HEM) and the Henderson Poverty Index (HPI).
The Household Expenditure Method
The HEM is the more widely used of the two methods and is based on more than 600 items in the ABS Household Expenditure Survey (HES). The HEM is calculated as the median spend on absolute basics (food, utilities, transport, communications, kids’ clothing) and the 25th percentile spend on discretionary basics, which includes expenses like alcohol, eating out and childcare. Non-basic expenses, for example overseas holidays, are excluded from calculations. Rent or mortgage payments are also not included in the HEM.
The Henderson Poverty Index
The HPI is less commonly used and was originally based on a survey of New York families in the 1950s, but has been updated using more recent Australian survey data. The index is calculated based on a family of two adults and two children, and it can be multiplied by a specific fraction to calculate a figure that applies to different family structures.
The HEM and HPI are very similar when applied to couples with two children; however, the HEM is less generous than the HPI towards singles and single-parent families.
The HEM is generally seen as the preferred method of calculating living expenses because it has been developed from the ground up based on Australian expenditure information, and also because it deals with each type of family separately.
Living expenses and your home loan application
When you apply for a home loan, you need to provide information about your living expenses. With some lenders this will simply mean providing a rough estimate of your weekly or monthly spend on essentials like rent, groceries, transport and utilities, but other lenders provide detailed calculators to garner a more accurate picture of your ongoing commitments.
The lender will then compare the living expenses figure you provide with the relevant HEM or HPI calculation for someone who lives in your area and has the same number of dependants. The higher of these two figures is then used as the basis to determine how much you can afford to borrow and comfortably repay.
Case study: John and Jane
To give you a better idea of how your personal circumstances can affect how lenders calculate your living expenses, let’s take a look at the example of 30-year-old newlyweds John and Jane. The couple live in NSW and don’t have any children. They rent an apartment, they’re both employed full time and they take an overseas holiday each year. According to the HEM, John and Jane have living expenses of $682 (not including rent). Over the course of a year, this amounts to a total expense bill of $35,472.
Now let’s assume that John and Jane have three dependant children whom they need to support. If all their other circumstances remain the same, John and Jane have living expenses of $1,124 per week (including rent), and total yearly expenditure of $58,470. That’s $22,998 more in expenses than a childless couple, which will obviously have a big impact on John and Jane’s ability to repay a home loan.
To put it in slightly more understandable terms, that’s a difference of $442 each week which could go towards regular home loan repayments.
|Married couple||Married couple with 3 kids|
|Yearly difference||$22,998 cheaper for a couple with no kids|
There are plenty of free online living expenses calculators to help you work out your average weekly spend. You can also use our How much can I borrow calculator to determine your borrowing power.