What’s My Borrowing Capacity For An Investment Property?
Before you can invest in property, you need money – pretty simple, right? But, when it comes to borrowing money from the bank, simple can start to feel pretty damn complicated.
Ideally you will have a minimum of 20% Deposit + approx. 5% Closing Costs (Stamp Duty, Solicitors fee etc). We recommend borrowing a maximum 80% of the purchase price … but that shouldn’t be a deterrent. People think that they have to save a lot more than necessary in order to get their property!
You may have saved a 25 per cent deposit. You may only spend a small portion of your credit card limit each month and pay it back in full. Or you may even be living with your parents on a rent-free basis.
Currently, even if you pay off the entire balance on your credit card by end of the month, and your outstanding balance is 0, the bank still takes 3% of your total credit card limit and deducts that off your monthly income.
Even if you are living rent free with your parents, the banks are taking minimum notional rent before calculating your borrowing power.
On the other hand, you may also be self-employed. Or you may have only just started working at your current job within the last year. Your credit card limit may be five figures, or you may have a few different cards.
When it comes to assessing how much they will lend you, banks look at more than just your income, deposit size and actual expenses. They assess a number of variables to determine whether you can pay back the loan in full. You may move out and start paying rent, max out your credit card or stop getting work. They need to consider these possibilities when calculating your borrowing capacity for an investment property – or any property!
It’s very important to know what your borrowing power is, before you submit your loan application. The first thing a bank does is, they access your credit report. Every time you go to a different bank, for the same application, there is a hit on your credit report. Too many hits could have a negative impact.
So, how can you find out how much banks will lend you? You need to understand the way lenders assess your borrowing capacity. This makes it possible to present your best self when applying for finance. But, before you approach any bank, it pays to speak with the experts first.
HOW DO BANKS ASSESS YOUR BORROWING CAPACITY?
In general terms, lenders will aggregate all sources of income and then subtract living expenses, monthly repayments on the new debt and monthly repayments on any existing debt. This will calculate the borrower’s Net Income Surplus (NIS). In other words, whatever money the borrower has left after making repayments and paying other living expenses.
Most lenders take the same sort of approach in determining serviceability. The way income and expenses are treated can vary somewhat across institutions however.
Not all forms of income are treated equally by lenders. If you are self-employed, or working on a casual or contract basis, most lenders will treat your income as being more subject to variance than that of those who are permanent, full-time wage earners.
The amount of time you have worked in your role may also affect the way lenders assess your income.
Uncertain income sources – such as investment income, rental income, commissions and bonuses – will likely be given a “haircut” by most lenders. This means they may only use a certain percentage of what you actually earn when calculating your NIS. The percentage used varies across financial institutions.
The same thing applies to Centrelink income such as Family Tax Benefit.
Generally speaking, most lenders will load up your expenses in the following way. Each will have a minimum benchmark based on the Household Expenditure Measure (HEM). This means that even if you are living with your parents, rent-free, and your actual expenses are below the HEM, the banks will use still use their minimum expense benchmark to calculate your NIS.
Having dependants increases this benchmark – again, actual expenses don’t factor if they fall below the bank’s minimum standard.
CREDIT CARD LIMITS
You may only spend $1,000 or so each month on your card and then pay it back in full, but if your limit is $10,000 – that is what the banks will use to assess your serviceability. In their eyes, that $10,000 is available to be spent and paid back with interest, regardless of whether you intend to use it or not.
When lenders calculate your NIS, not only do they discount your income and load up your expenses, they also increase the interest rate on repayments. This interest rate “buffer” is in place to make sure you can still service the loan when rates rise.
On top of this “assessment rate” many some banks will calculate your NIS as if you were making both principal and interest repayments, even if you are actually paying interest on the loan.
Banks apply the above-mentioned assessment buffers to any existing home loan debt you may have. So, even if you are only paying interest repayments at 4.5 percent on your loan, the lender may assess your serviceability based on if you were paying both interest and principle repayments at 7.25 per cent, for example.
LOAN TO VALUE RATIOS
Your loan to value ratio (LVR) can affect the amount of money that banks are willing to lend you. If you are borrowing at an LVR of more than 80 per cent, most lenders will require Lender’s mortgage insurance to cover any potential default. This insurance protects the lender, not the borrower. However, the cost is transferred to the borrower in excess fees. This added cost may affect your serviceability.
In addition to this, many mortgage insurance providers require a higher NIS than what the lender may accept. For instance, hypothetically speaking, a lender may accept a loan application with a NIS of one dollar per month, but the mortgage insurer used won’t provide cover unless the NIS is $30 or higher (this figure is just for illustration purposes and not based on expected real life figures!).
SO, HOW MUCH CAN YOU BORROW?
Early in 2016, in an address to the Macquarie University Financial Risk day conference, the General Manager of APRA, Heidi Richards, said:
“Mortgage lending at four times gross income is relatively common, at one-third of all new housing loans. Lending at six times or more of gross income is much smaller but still material – nearly 10 per cent.”
This suggests, as a rule of thumb, borrowers may reasonably expect to be able to borrow four to five times their gross income.
LENDING IS A CASE-BY-CASE SCENARIO
Kabir Hussain, Finance Manger for Zinger Finance, says lending is very much a case by case scenario that is dependent on the borrower’s serviceability and credit history.
For instance, let’s say borrower 1 and borrower 2 (B1 and B2) both earn $80,000 a year. B1 is employed on a contract basis and has to reapply for his job at the end of his 12-month contract. In contrast, B2 is employed on a permanent full-time basis and has worked in the same job for the past three years.
In the banks’ eyes, B2 has a more secure form of income, so he is more likely to be able to borrow up to five times his income.
On the other hand, B2 is divorced with three children for whom he pays child support. B1 is single with no children. In the eyes of the bank, B2 has a much larger living expense. This reduces his NIS, reducing the amount the bank is subsequently willing to lend.
Now, B1 and B2 are on more equal footing.
In addition to assessing your serviceability, banks will also look at your credit history to determine the level of risk in lending you money. Your credit file shows every line of finance you have ever been approved for, including home loans, personal loans, car loans, and even mobile phone plans.
If you shop around for finance, applying unsuccessfully for loans at several banks, you are painting an unfavourable image of yourself to other lenders who may have approved your loan application otherwise. This is exactly why you should arm yourself with some expert knowledge before approaching lenders individually.
WHAT SHOULD YOU DO TO PREPARE?
Kabir says, “it’s important to be in control of your paperwork and have all income and expense statements in easy reach. This will enable you to have the most accurate picture of your monthly finances and prevent you from leaving anything out by mistake.”
He says that it also helps to be able to demonstrate a good savings history. Lenders like to see those who can show a regular savings pattern on their bank statements. For many, this may mean “managing their statements” so that account usage patterns demonstrate consistency and financial control. Ie, don’t just go and withdraw $300 every day for a week – plan how much you need for the week before taking money out.
Checking your credit file before approaching a lender or broker is also a good idea. There are several websites that allow you to delve into your file – but, beware, they aren’t all free. Some require an ongoing paid subscription, so make sure you read the terms and conditions.
WHO CAN HELP?
Once you have all of your paperwork in order and you know what you want to achieve with your investing, it helps to speak with a broker who is an expert in helping property investors build the sort of success you are after. A good broker should be able to find the best lender for your needs and find out how much you are able to borrow.
Beyond this, your broker should be part of an overall team of professionals who are skilled in building high performing property portfolios. The right success team will be able to help you strategically align your actions with your goals, and prevent you from making the wrong choices on your investing journey.