Buying a new home is a big decision, and is one of the most expensive investments of your life, too. But before you even start to look for that dream home, you should find out how much you can borrow. This will help you narrow down your search and get an idea of what your repayments will look like in the future.
Understanding your borrowing capacity
Borrowing capacity estimates the maximum amount a lender will lend you with a home loan. Each lender calculates borrowing capacity differently. They each rely on a range of factors to work out the number, and these factors may be different. However, many of these factors are also the same, like income details, general living expenses, current assets, debts, number of dependents and even credit card limits.
You’re also typically required to provide a 20 per cent upfront deposit. Most lenders will only let you borrow up to 80 per cent of the property value unless you pay lender’s mortgage insurance (LMI).
Here’s what lenders typically look at while calculating your borrowing capacity:
This includes your basic salary, any bonus payments and overtime that you earn regularly. It also includes any income you get from other investments such as properties you rent out, shares or other investments.
Lenders calculate your disposable income by deducting your total expenses from your gross income. Expenses include everything from your utility bills, kids’ school fees and your average grocery shopping.
Debt-to-Income (DTI) Ratio
Lenders use the debt-to-income ratio to judge your ability to repay the home loan. This ratio identifies the percentage of your income, typically monthly, that could be applied to servicing recurring debts. They will look at the current recurring debts like credit card payments, education or car loans to see how mortgage repayments will impact your financial health. Generally, a DTI over six is considered high risk. Lenders believe that a DTI over six can put you under financial stress if:
- Your situation changes suddenly.
- There’s a dramatic rise in interest rates.
Here’s an example of how lenders may calculate DTI. Let’s say your annual income is $100,000 and you want to borrow $500,000 for a new home. You also have an outstanding education loan of $10,000, and a credit card with a monthly limit of $1,000.
Therefore, your total liabilities are:
- $500,000 – New mortgage
- $10,000 – Education loan
- $1,000 – Credit card monthly limit
To calculate your DTI, the lender will divide your total debts by your income ($511,000 / $100,000) to arrive at a figure of 5.11. This means your total debt is 5.1 times your gross income, and this doesn’t include monthly bills or expenses. A lower mortgage amount will obviously reduce your DTI, which is why this figure impacts your borrowing capacity significantly.
What size home loan can I get?
Lenders use some complicated calculations to decide what size home loan you can borrow. However, it makes sense to crunch the numbers on your own to get an idea of your budget before you plan your property purchase.
To make things simpler, look at the following figures to determine how much you might be able to borrow:
- Your annual income (including any regular bonuses, rental income, or other investments etc.).
- Your average expenses.
- The size of your deposit.
Once you’ve got a fair estimate, you can use an online borrowing capacity calculator to get an idea of how much money you may be able to borrow. You can then use this figure and a loan repayment calculator to work out your monthly repayments. You’re likely to be the most comfortable, financially, if your monthly repayments are equal to your current rent costs. For anything extra, you’d either need to downsize your loan or rework your budget to make room for the additional cash.
What size home loan can I afford?
When you apply for a mortgage, the amount you’re eligible for might differ from the amount you can comfortably service. Suppose you have a high income, but your credit score is low. In that case, the size of the home loan you qualify for might be less than what you can afford to comfortably repay.
On the other hand, you may qualify to borrow a much larger amount than you can actually afford in monthly repayments. If this is the case, it’s better to borrow only as much as you can afford without compromising your monthly necessities, leading to undue stress. Some home buyers also prefer to calculate their monthly repayments at a higher interest rate (at least 2 to 3 per cent more than the current average interest rate) in preparation for future interest rate hikes.
If you’re confused about how much you can borrow or need help finding the right home loan, contact a mortgage broker. They will offer an obligation-free service to better understand your options and give you personalised advice.