When you’re applying for a home loan, the amount you’re eligible to borrow may be different than the amount you actually should borrow.
Banks have some sophisticated systems for deciding the maximum amount of money they will lend you. They take into account all your assets and liabilities, look at the median spending habits for people in similar situations and build in interest rate buffers to ensure that you can still afford your home loan should rates rise.
What banks can’t take into account is your particular personality. Only you know your own budgetary discipline. This means you need to take into account not just how much you can borrow, but how much you should borrow.
How banks decide what you can borrow
Lenders decide how much you can borrow based on serviceability calculations. These calculations take into account your income from various sources along with your expenses. Lenders then look at the proposed debt as a proportion of your monthly income and build in a buffer for potential interest rate rises.
When calculating your expenses, lenders vary in their approach. While some look at your actual expenditure, others use models that estimate your expenses. They do this by looking at the median Australian household spend for basics such as food, utilities and transport, and then adding in a set amount for discretionary spending.
Based upon the lender’s calculations of your monthly expenditure and your monthly income, lenders will decide the maximum amount of additional debt they believes you can service. In deciding on the size of the home loan to offer you, lenders will also take into account the type of property you’re buying and the size of the deposit you have.
How you should decide what you can borrow
What the bank will lend you may differ from the amount you feel you can comfortably repay. In some cases, a lender’s estimate may be on the low side, and you might be disappointed by the maximum amount available to you. In other cases, a lender may be willing to extend you more credit than you feel comfortable accepting.
Before you decide how much you should borrow, you need to ask yourself a few questions:
What kind of lifestyle do I want?
In all likelihood, taking on a home loan means you’ll have to make a few changes in your lifestyle. While home ownership comes with many positive lifestyle changes, it can also mean some changes that might not be so welcome.
Taking on the responsibility of a home loan could mean you’ll have to curtail your spending in other areas. If you’re used to going out, spending on takeaways or buying a lot of discretionary items, you may have to significantly adjust your lifestyle once you have home loan repayments to make. How significantly will depend on how much you borrow.
To get an idea of the amount a home loan will add to your monthly expenditure, you can use the repayment calculator below. You can look at various borrowing scenarios to see what your repayments will be if you borrow different amounts.
Before deciding on the amount you’re comfortable borrowing, have a look at your current average monthly expenditure. Once you’ve figured this out, honestly assess what sacrifices you’re willing to make to pay your home loan repayments.
Am I comfortable paying LMI?
One of the factors that will determine the amount lenders will offer you is the size of your deposit. Some lenders will approve home loans with as little as a 5% deposit, but if you choose to take this option, you’ll find yourself paying lenders mortgage insurance (LMI).
LMI is an insurance policy that covers your lender in the event you default on your home loan. It’s charged when you borrow more than 80% of the value of the property you’re buying. LMI can add thousands of dollars to the cost of a home loan and will end up increasing your home loan repayments.
If the added burden of paying LMI is too much, you might need to rethink the amount you want to borrow. If you can keep your loan-to-value ratio (LVR) below 80%, you can avoid having to pay this added expense.
How disciplined am I?
Once you’ve decided on the kind of lifestyle you’re comfortable with, you’ll have to assess whether you have the discipline to stick to your new lifestyle.
You’ll need to take an honest look at your own financial discipline before you decide to take on a home loan. It takes a fair amount of discipline to service any home loan, but a home loan debt that substantially increases your monthly expenditures will require a very disciplined approach.
While it’s important to work out a budget based upon the standard of living you’d like to have, sticking to this budget will be the difficult part. If you have a budget and find that you typically overspend, you need to factor this into your assessment when deciding how much to borrow. If financial discipline is difficult for you, leave yourself some leeway in your home loan repayments.
What life changes might be on the horizon?
A budget and an honest assessment of your discipline will give you a good idea of the home loan you can afford right now, but you’ll also want to prepare yourself for the future. Any life changes could impact your ability to repay your home loan. Although some life changes are unforeseeable, you can factor others into your financial plan right now.
If you plan on having children in the next few years, you’ll want to factor this added expense into your calculations. Likewise, if you’re looking at a career change in the medium term, think about the impact this could have on your income.
If you’re borrowing as a single person, you might want to consider the possibility that one day you’ll be repaying your home loan as a couple. Adding another person to the mix can help alleviate some of the financial burden, but keep in mind that you’ll also be adding that person’s debt and expenses to what you need to pay.
You might not be able to predict all of the life changes that could happen during the term of your home loan, but it’s wise to leave yourself some breathing room just in case.
What extra costs will I face?
The expense of a home doesn’t end with a home loan. Before you even move in, you’ll also need to budget for a variety of expenses involved in the home buying process. You’ll likely have to pay stamp duty, legal fees and fees for building and pest inspections. After the home loan settlement, you’ll also have to pay for removalists to help you move into your new home.
There are also ongoing expenses associated with homeownership. In addition to your home loan repayments, you’ll have to factor in home and contents insurance payments, council rates, utilities, maintenance and upkeep. Depending on the type of property you move into, you may also have strata or body corporate fees.
These costs add up and can be a significant monthly expense. When deciding on how much you should borrow, you should keep these ongoing expenses in mind along with your home loan repayment.
Lenders are fairly conservative in their assessment of what you can afford. It doesn’t behove them to lend money that borrowers are unable to repay. But as conservative as they might be, they can’t factor in some of your unique personal circumstances. By taking the time to assess your own lifestyle and financial discipline, you can make sure you don’t take on more than you can afford.