When it comes to securing a home loan, one of the most crucial factors to understand is your borrowing power. This term refers to how much a lender is willing to lend you based on your financial situation. While each bank or lender has their own formula for determining borrowing power, understanding the basics can help you plan ahead and make more informed decisions.
At Bluestone Home Loans, we believe in empowering borrowers with knowledge. In this blog, we’ll break down what borrowing power is, how banks calculate it, and how you can manually estimate your own borrowing power before you apply for a loan.
What is Borrowing Power?
Your borrowing power is essentially the maximum amount of money a lender will be willing to lend you based on a range of factors. These factors include your income, expenses, existing debts, and the overall risk you represent to the lender.
Borrowing power is not just about how much money you make; it’s about how much of your income can be directed towards repaying a loan after covering your living expenses, other financial commitments, and any risk factors that might be involved (e.g., changes in interest rates or your employment status).
What Lenders Consider When Determining Borrowing Power
Lenders assess borrowing power through a combination of criteria, and while each lender may have its own specific policies, these are the key factors typically considered:
- Income: Your monthly or annual income is a primary factor in determining your borrowing capacity. Lenders typically use gross income (before tax) to calculate your potential loan amount.
- Expenses: Banks also take into account your regular living expenses, such as rent, utilities, food, and insurance premiums. They may also factor in other personal expenses like school fees, car loans, or credit card repayments.
- Existing Debts: Any current debts you have, including credit cards, personal loans, or other mortgages, will impact your borrowing power. Lenders want to ensure that you can comfortably manage new debt alongside existing obligations.
- Credit History: Your credit score or credit history often plays a role in your borrowing power. A higher credit score typically leads to better loan terms and higher borrowing power, while a low score can limit the amount you’re eligible to borrow. At Bluestone, we consider more than just your score, considering your full history, even you have imperfect credit.
- Loan-to-Value Ratio (LVR): Lenders will also assess how much of the property’s value you are borrowing. A lower LVR (for example, borrowing 80% of the property value) is considered less risky for the lender, which could improve your borrowing power.
- Interest Rates: The current interest rates of will impact your monthly repayments, which in turn affects your borrowing capacity. Lenders often assess your ability to repay the loan at a slightly higher rate than the current one, factoring in potential rate rises.
- Deposit Size: A larger deposit can reduce the loan-to-value ratio (LVR) and improve your borrowing power, as it shows the lender that you have more equity in the property.
- Employment Stability: Lenders want to see stable employment history and income. Job security is an important factor in determining your ability to repay a loan over time.
- Other Financial Obligations: If you have dependents, child support payments, or other ongoing financial commitments, lenders will include these in their assessment to ensure you have sufficient disposable income to service your mortgage.
How to Calculate Your Borrowing Power
While lenders will use complex algorithms and software to calculate borrowing power, you can get a rough estimate on your own by considering the following steps:
Step 1: Calculate Your Monthly Income
Include all sources of income, such as your salary, rental income, or any other regular earnings. If you’re self-employed, lenders may average your income over the past two years to account for fluctuations.
Example:
If your gross monthly income is $6,000, that’s the starting point.
Step 2: Add Any Additional Income
If you have a second income, rental income, or dividends from investments, add those amounts as well.
Example:
Rental income from an investment property: $1,000
Total monthly income = $6,000 + $1,000 = $7,000
Step 3: Subtract Your Monthly Expenses
Next, calculate your regular living expenses. These could include things like rent, utilities, food, insurance, and any loan repayments you’re already making (such as car loans or personal loans). Lenders may ask for detailed breakdowns, but you can use a rough estimate here.
Example:
Living expenses: $3,000
Other debt repayments: $500
Total monthly expenses = $3,500
Step 4: Calculate Your Serviceability Ratio
Lenders typically want your debt-to-income ratio to be below a certain threshold, which is usually around 30-40%. This means that no more than 30-40% of your gross income should be going towards debt repayments.
For example, if your monthly income is $7,000, 40% of this is $2,800. If your mortgage repayments exceed this, it may impact your borrowing power.
Step 5: Speak with a Broker
Now that you’ve got a little more knowledge on your financial position, you’re armed for a really productive conversation with a broker. To get a more accurate picture of your borrowing power, we always recommend you consult with a mortgage broker. Broker will take into account additional factors such as interest rates, LVR, and other financial obligations that you may not have accounted for.
Why Lenders Use These Criteria
The goal for lenders is to ensure that borrowers can comfortably repay the loan without undue financial strain. By assessing factors like income, expenses, and debt, lenders want to make sure that you’re not overextending yourself and that you’re able to meet your financial obligations throughout the life of the loan.
Understanding the various components of your borrowing power and how they are calculated can help you make strategic decisions about your loan. If you’re looking to borrow the maximum amount possible, increasing your income, lowering your expenses, paying off high-interest debt, and saving for a larger deposit are some of the most effective ways to improve your borrowing power.
Your borrowing power is a key factor in determining your ability to secure a home loan and the amount you can borrow. By understanding the factors that influence your borrowing power and learning how to calculate it manually, you’ll be better prepared to make informed decisions when applying for a home loan.
If you don’t already have a broker, we can help point you in the right direction HERE
