So, you’ve saved up a deposit and you’re ready to buy a property, it’s important to understand how banks will determine if you can service a loan. As lenders have a legal obligation to lend responsibly, they will take into account several different variables such as income, debts and expenses to determine if they will lend you the money. If they lend you the money, then you have shown that you can ‘service’ the loan.
What does ‘servicing’ mean?
When a lender calculates your serviceability, they are essentially gauging your ability to pay off a loan. They do this by looking at your income and expenses (among other factors) and determining how much you could comfortably afford to pay.
How is loan serviceability calculated?
In simple terms, the lender will take into account your income from all sources and subtract your expenses and other debt commitments to determine serviceability. Every lender has slight variations to policy and here are a few factors that should be noted:
All income is not the same – all income such as salary, rental income, interest from investments, Centrelink benefits, etc. is taken into account for calculating your serviceability. However, whilst 100% of your salaried income will be considered, only 80% of rental income will be considered. If you have a second job, the income may only be taken into account if you’ve been in that job for at least a year. However, select lenders aren’t as strict when calculating income which can massively boost your serviceability. As a mortgage broker I can help navigate these factors.
Lenders use a ‘buffer’ – lenders will want to ensure that if rates go up, you’ll still be able to service your loan. To do this they apply a buffer on the current interest rate when determining the proposed repayments. This rate is referred to as the ‘assessment rate’ and is, on average, 2.5% higher than the market rate.
Other Commitments (Liabilities) – lenders tend to err on the side of caution when assessing your current liabilities such as credit cards, car loans, rentals, etc. Because of this, a high credit card limit could be detrimental to your servicing. Even if you pay off the credit card every month and have never missed a repayment, the lender will use the total limit and apply their repayment rate to it.
What is the measure of serviceability?
Each lender has it’s own criteria for calculating servicing and they all adopt different policies. However, generally lenders calculate servicing through the following methods:
Debt-to-Income Ratio (DTI) – The ratio identifies how much of your monthly income is applied towards the payment of recurring debts such as credit card payment, personal debt, mortgage repayments or car loan. Therefore, if you’re apply for a $500,000 loan and have a gross annual income of $100,000, your DTI is 5 ($500,000/$100,000).
Net Surplus Ratio (NSR) – NSR measures your after-tax ability to service additional debt after allowing for existing debts and living expenses. In order to obtain a loan, the NSR must be equal to or greater than 1.
Surplus Monthly Income – This figure indicates the amount you’d be left with every month after paying off all your monthly expenses and home loan repayment.
How to increase your serviceability?
Whilst the above information may appear daunting, it is possible to increase your borrowing power with the following steps:
Reduce your expenses – a good household budget can help reduce your expenses significantly which shows the lender that your ability to make repayments is strong. This is an easy step which can be implemented by every borrower.
Increase your income – this step may not be as easy but increasing your income will also increase your borrowing power.
Reduce your ongoing commitments – decreasing/ removing your ongoing commitments will free up cashflow that can be used to service a loan. If you have a credit card limit of $20,000 it’s worth thinking about whether this can be cancelled or reduced to an amount that you could still manage. The less debt you have when applying for a loan the better your servicing will look to a lender.
Navigating lender policy and determining your servicing can be difficult. Contact me to find out more about loan serviceability. I’m across the latest loan application criteria used by lenders so I can advise which lenders are a good fit, taking into account your overall financial picture.