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How to avoid overstretching your home loan budget

Mark Bristow avatar
Mark Bristow
- 8 min read
How to avoid overstretching your home loan budget

The more you can borrow for a home loan, the higher the property prices you may be able to afford. While this could let you purchase your dream home or investment property, pushing your finances too far could risk putting you in mortgage stress.

Try to keep your repayments under 30 per cent of your income 

While it’s not a formal definition, a rule of thumb commonly used to measure mortgage stress is how much of your household income goes toward servicing your home loan. If more than one third of your take-home income would be used for mortgage repayments, you may be in mortgage stress.

With more than one third of your money going toward your mortgage, you may be left in a tight spot if your circumstances were to suddenly change. You could lose your job, be seriously injured and unable to work, or you may suddenly have a large expense to manage, such as paying for car repairs after an accident. Adding another child to your family could also put more pressure on your budget, as more dependents means more expenses.

It may not be easy for every household, but if you can find ways to increase your income, you may be better positioned to weather future financial storms.

Use a buffer rate in your calculations

Home loan interest rates don’t stay the same for the full duration of your loan term. Over the 20-to-30-year term of your home loan, you can realistically expect to see your interest rate change more than once. Even if you fix your rate, this will eventually revert to a variable interest rate that will rise or fall over time.

When your interest rate rises, such as when the Reserve Bank of Australia (RBA) increases the cash rate and mortgage lenders pass on this hike, your home loan repayments may increase significantly. One way to help limit the impact that rate rises could have on your home loan is to use a buffer rate when calculating what home loan repayments you could afford.

Most mortgage lenders ‘stress test’ home loan applications to calculate if they could still afford their repayments if interest rates were to rise. Introduced in 2014, the serviceability buffer required by the Australian Prudential Regulation Authority (APRA) was at least 7 per cent, meaning that any applicant would need to show they’d still be able to afford their repayments if interest rates rose this high.  In 2019, this rate was dropped to the mortgage rate plus 2.5 per cent, then increased to the mortgage rate plus 3 per cent in 2021.

You could make your own estimates of whether you may be able to afford a home loan product by running the numbers through a mortgage calculator at its current rate, then at its current rate plus 3 per cent. So, if you were applying for a home loan with a 4 per cent interest rate, you may want to calculate the repayment on a 7 per cent home loan. If you could still afford these repayments, your application may have a stronger chance of approval.

Keep in mind that individual lenders consider different factors as well as the floor rate to work out your maximum borrowing amount and whether they’ll approve your home loan application. Your own calculation may serve as a useful estimate but isn’t a guarantee of approval.

Try to maintain a low Debt To Income ratio

Your Debt To Income (DTI) ratio measures how much you owe compared to how much you earn.

For example, imagine you earned an annual income of $150,000, and have an outstanding car loan of $10,000, as well as a credit card with a $4000 limit. If you were to apply for a $500,000 home loan, you’d have a total debt of $514,000. Compared to an income of $150,000, this would give you a DTI of 3.43.

Some lenders use the DTI to estimate the risk of providing you’re a home loan. If you owe significantly more money in debts than you earn in income, the more trouble you may be in if your financial circumstances were to change, and the higher the risk you may represent to the lender. For example, if your debts would be more than six times your income, a lender may be less inclined to approve your loan application, though some lenders may have different levels of risk appetite.

Pay a larger deposit if possible

Saving up the deposit for a home loan is often the hardest part of the process. With house prices being so high in Australia’s capitals, the time and effort required to save up the 20 per cent deposit needed to avoid Lenders Mortgage Insurance (LMI) may not seem worth it.

That said, the more of a property’s price you can pay upfront as a deposit, the smaller your loan will be. This can help make your mortgage repayments much smaller, and ease some pressure on your budget.

For example, here are the calculated costs involved to buy a property valued at $500,000 with different deposits, assuming a 4 per cent interest rate and a 25-year loan term:

Deposit

Loan amount

Monthly repayment

Total cost

20% ($100,000)

$400,000

$2111

$633,404

10% ($50,000)

$450,000

$2375

$712,579

5% ($25,000)

$475,000

$2507

$752,166

Source:RateCity. Calculations are estimates for illustrative purposes only, and do not account for fees, charges, or changes to interest rates over time.

Of course, to enjoy these benefits, you’ll still need to save up that deposit of 20 per cent or more – the higher your deposit, the lower the rate you may be able to pay. You may be able to get support from the government or a family member as a guarantor or co-borrower to help get a loan with a low deposit without paying LMI, but your larger loan may mean higher repayments.

Use flexible repayment options where you can

Many home loans offer options to give you some flexibility around your repayments. The simplest of these is the ability to make extra repayments of more than the minimum amount required. The extra money you pay goes directly towards lowering your outstanding mortgage principal, which can bring you closer to paying off your loan faster and reduce the interest you’re charged.

A redraw facility can let you access extra repayments you’ve made in the past in case you need that money back in a hurry, such as when budgeting for a surprise expense. An offset account is a transaction account linked to your home loan, where money you deposit is used to offset your loan principal when calculating your interest charges. The more money you can save in your offset account, the less interest you may be charged on your repayments, and the faster you may be able to pay off your loan.

It may require a little forward planning, but paying some extra money towards your home loan and/or your offset account when you can afford to could help to relieve some of the financial pressure when times get tough in the future. Think of it like saving for a rainy day – if money starts to get tight, you may be in a better position to make changes if you’re already ahead on your loan and/or are paying less interest.

Avoid applying for “liar loans”

Mortgage lenders calculate your maximum loan size based on your income, expenses and more. When you apply for a home loan, it may be tempting to look for ways to exaggerate your income and/or minimise your expenses so you can get approved for a bigger loan and buy a higher-priced property.

However, taking out a bigger loan than you can realistically afford could leave you in a difficult position if your financial situation was to change, such as if you lost your job, had to manage unexpected expenses, or if interest rates were to rapidly rise. Also, intentionally stretching the truth on a home loan application could be considered fraud, and risk landing you in legal hot water. 

While it can be frustrating to miss out on buying your preferred properties, and to jump through hoops of paperwork to get a home loan approved, completing the application process can help to make sure you can comfortably afford your loan repayments, minimising the risk of stretching your budget.

For more help with your home loan application, you could consider contacting a mortgage broker. These home loan experts can also help you compare home loan options and work out which options could best suit your personal goals and household budget.

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Product database updated 28 May, 2024

This article was reviewed by Personal Finance Editor Alex Ritchie before it was published as part of RateCity's Fact Check process.