A guide to borrowing responsibly

What you can borrow and what you should borrow are very different numbers, a guide to understanding the difference and living within your means

What size loan is right for me?

While home buyers usually focus on asking how much can I borrow, it’s equally important to ask how much should I borrow? – in order to arrive at a figure where you can comfortably manage the mortgage repayments each month. While it’s tempting to borrow the absolute most you can in order to buy the property you are after, it’s important to be realistic and consider the financial implications.

When arriving at your figure, it’s vital to include the added costs that come with buying a house, such as stamp duty, council and water rates – not to mention any maintenance and repairs that may need to be carried out prior to you moving in – and then factor in a bit more to act as a buffer in the case of an interest rate rise.

A UNO Broker can help answer any questions you may have about your borrowing capacity, your loan to value ratio (LVR), loan, and repayments, so you can choose a loan size that suits you.

Need to know:

  • Fixed versus variable rates
  • Loan-to-value ratio
  • Cost of living and expenses
  • Credit score

Fixed versus variable rates

When it comes to choosing a home loan, one of the basic decisions you’ll need to make is whether to select a fixed or variable rate.

A fixed rate allows you to lock into the same rate for a certain period of time (usually 1 year, 3 years or 5 years). This protects you from rate rises – but also means you are locked into a rate if rates go down. Many first home buyers choose a fixed rate to kickstart their home loan term, to give them a chance to start making repayments at an amount they know they can afford. If you decide to exit the fixed rate period before the end of its term, you will be charged a break cost.

A variable rate is a loan product that has a fluctuating interest rate, meaning if the RBA changes the cash rate, your lender will most likely change your interest rate to reflect the change. This will increase or decrease your mortgage repayments.

There are a host of other rate types and package terms you may have heard of. Here are a few definitions of each:

A standard variable rate is the rate your lender reverts to when a loan’s fixed rate period expires.

Required by legislation, a comparison rate serves to give an indication of the ‘true cost’ of the loan. It is the interest rate of the product taking into consideration ‘some’ of the fees involved in the mortgage process, expressed as a percentage. Generally, the fees included are the upfront (mandatory) fees and some ongoing loan service fees. The comparison rate excludes any event-based fees such as costs incurred if you change the terms of your product after the contract is drawn up, for example switching from principle and interest repayments to interest only repayments.

A split loan is a loan that is divided between multiple products/types. A common split is to have one part fixed rate, the other variable. The reason for having a split may be to get partial benefits of each product. For example, an offset account may only be available on a variable rate product, but the customer also wants to fix a portion of their loan repayments to have greater stability. Be aware that some lenders limit the number of splits available.

The assessment rate is the interest rate used when the lender is assessing the serviceability of your loan. It is generally higher than the rate of the product you are applying for, for example if the product’s interest rate is 5%, the lender may assess you on your ability to pay off the loan if the rate is at 7%.

How much is safe to borrow for a mortgage?

The amount that you deem safe to borrow will depend on your income, expenses and lifestyle, as well as any future plans and aspirations you may harbour. Do you plan to study in a few year’s time and quit your job – or work part-time? Are children on the agenda for you and your partner? Do you have ill or elderly family members that you may need to care for in the future?

Other things to consider include:

  • Renovations: does the place you’re buying need a new kitchen before you move in? Or a new coat of paint?
  • Current debts such as student loans, credit card debt, or personal loans. These will lower your borrowing capacity so you may like to think about paying these off before you take out a home loan.

These things can not be put into a calculator but should nonetheless be taken into account when you think about what you can afford to borrow. It’s about finding the right home loan that will help you live the life you want to live, without too many sacrifices.

Set your limit and don’t overcommit: while there’s no harm looking at an $800k home if your budget is $700k, if you actually cannot afford an $800k home then don’t go to the auction and bid more than you can afford to.

How much can you borrow against the equity in your home?

Theoretically, you can borrow up to 80% of the equity in your home (some lenders will let you borrow up to 90%) however your income, capacity to pay back the loan and other factors may reduce the overall amount. You can use the equity in your home for a number of different reasons, such as renovations, a new car, a holiday to Ohio. You can also use equity to consolidate debt, adjust your loan term, switch from a variable rate to a fixed rate, or vice versa, and to access different home loan products.

To find out how much equity you have in your home, you’ll need to have a property valuation. If your home is valued at $500,000 for example, and you owe $100,000 on your mortgage, you can likely borrow around $320,000 (80% of $400,000).

How many times your income can you get a mortgage for?

How much you can safely borrow essentially comes down to three very simple factors: the size of your deposit (and additional cash for costs), the size of your (possibly combined) pay packet and your expenses.

Back in the day, banks might arrive at this figure by roughly estimating 4 or 5 times your salary. These days lenders are much more stringent and many things are taken into account before arriving at your pre-approval figure.

A good rule of thumb to work it out yourself, according to Pedersen-McKinnon, is to multiply your savings as they grow by 10 until you get a figure large enough to buy something somewhere you’d think about living.

She writes: “So, if you had $30,000 allocated for the deposit, you could consider paying up to $300,000 for a property. If you had $70,000, you could possibly go up to $700,000. If you’re a first-time buyer, you should stop roughly between a hovel and a stately home.”

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What sort of home can I afford on $40k/$80k/$100k a year?

While the more money you earn will increase your borrowing power, the best way to work out your borrowing potential is to use UNO’s how much can I borrow calculator or speak to an adviser. As well as your income, your living expenses, debt and future plans need to be taken into account, as well as the size of your deposit.

Using UNO’s calculator, if you’re earning $40,000 a year and estimate your living expenses to be roughly $500 in monthly payments, you may be able to borrow between $200,000 and $260,000, depending on the lender for an owner/occupied property.

If you’re a single person with an income of $80,000, living expenses of approximately $16,000 a year and a credit card with a $5000 limit, the UNO calculator estimates your borrowing power somewhere between $411,161 and $511,165, depending on the lender.

And, showing while it’s always a good reason to ask for a pay rise, if that same person now has an income of $100,000, there’s borrowing power increases to somewhere between $$532,814 and $662,407 depending on the lender.

Of course it’s a good idea to speak to an UNO consultant who can work out a more accurate estimate.

How do lenders work out my living expenses?

Lenders will ask you about your living expenses and rely on you providing them with an honest estimate. They also refer to the Household Expenditure Measure (HEM) as a guide, which suggests a single person’s average yearly expenses are around $16,000 (or $1200-1300 a month).

For couples it’s around $35,000 annually and $3-4000 annually is added on for each dependant.

Can you borrow against your house to buy another house?

Borrowing against one house to buy another is a common scenario. You are essentially using the equity you’ve accrued in one home to pay for another. As mentioned above, theoretically, you can borrow up to 80% of the equity in your home (some lenders will let you borrow up to 90%) however your income, capacity to pay back the loan and other factors may reduce the overall amount. If your home is valued at $1 million, and you owe $500,000 on the mortgage, you can essentially borrow up to $400,000 to put towards another property.

Another way to do this is to act as guarantor – either for yourself, or someone else, such as a child. A guarantor is legally responsible for paying back the entire loan if the borrower cannot or will not make the home loan repayments. The guarantor will also have to pay any fees, charges and interest.

How much can you borrow as an investor?

There’s a greater deposit requirement for investment properties: typically 10% of the purchase price plus costs.

A key thing to look at is cash flow and what you expect from the investment property in terms of rental income and all the costs associated with ownership. A major one is your home loan repayment costs. Council rates, maintenance on the property, and property manager’s commission should all be factored in, and you should think about what you would do in the case of a vacancy period between tenants. If there is any deficit in that cashflow, you as the owner/borrower are responsible for making up that deficit from your other income sources.

Lenders will take all these things into account when they work out your borrowing capacity.

Negative gearing? Please explain

As much as it sounds like that thing that happens when a manual car stalls, negative gearing is not that. It’s the deficit that occurs when the cost of owning a property (including interest costs) are greater than the income you are earning on the property.

If you are making a negative profit on an investment property, it does provide some tax advantages but it means you have to cover that deficit from a cash flow point of view.

Say the overall costs, including interest, of owning the property are $1000 per week, but the property is fetching $750 in rent per week. This provides a potential reduction in tax of $250 a week. You do still need to pay that $1000 a week – so the key thing to note is that $250 has to come from somewhere, i.e. your salary.

Higher income earners tend to negative gear on purpose, because of the aforementioned tax benefits and because they plan to gain from the increased value of the property over time. For example they might purchase property for $750k and three years later sell it for $1.2 million.

Investors need to understand their risk profile around capital gain and rental return. Get started online.

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October 26, 2023
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