If you’re applying for a home loan, you probably want to know how to calculate borrowing power.
In fact, it’s the number one question people want to know.
This topic is quite detailed and sometimes a bit dry because we’ll be digging into the details, so you can properly understand how lenders analyse your situation.
Learn How to Calculate Borrowing Power for yourself
Every lender has their own unique formula for calculating your borrowing power (also called borrowing capacity) and is referred to by your Lenders as your home loan serviceability.
The term serviceability comes from an assessment that you are able to service your loan commitments.
Your income is validated differently from bank-to-bank, to satisfy their own serviceability calculator.
Here’s what your lender will want to analyse:
- Gross Income
- Income Type (is it salary, commission, overtime, allowances, rental income, investment income, or something else?)
- Liabilities (what are they, how much do you owe, what are the repayments?)
- Cost of Living (and other expenses or financial commitments)
- Dependants (How many? What’s their age?)
There’s various buffers included within the calculation to ensure long term serviceability.
Buffers may be used to reduce your income (to determine your assessable income), or to add margins on top of interest rates. Or both.
Your lenders serviceability assessment is for the purpose of ensuring long term affordability over the entire term of your loan, not just today.
The Borrowing Power Formula
Your borrowing power calculation is about ensuring you have enough income to pay for your commitments (liabilities and living costs).
There’s also two calcuations that most lenders will undertake.
- Total Net Income – Total Repayments – Living Costs = Your Net Surplus Income
- Total Debt / Total Gross Income = Debt to Income Ratio (DTI)
Total loan repayments are generally calculated with a 2.5% buffer added to the interest rate (to stress test that you can pay your loan over the long term). Your lender may also have a minimum net surplus amount.
Additionally, the DTI when greater than 6 or 7 may cause some lenders to decline your application (eg. if your income is $100,000 and your total debt is $700,000 then your DTI = 7).
This assumes your lender actually accepts 100% of your gross income.
When calculating your borrowing power – your Gross Income will differ between lenders, as they alter it to determine your “Assessable Income” (it varies based on differences in unique bank-to-bank credit policy).
How to calculate borrowing power for your employment type
Watch this video to see a real-life serviceability calculator in action. Most banks use one almost exactly the same as this.
If you’re self-employed, there’s an interesting hack to TRIPLE YOUR BORROWING POWERfrom $257,000 to $856,000! (skip to 5 min 41 sec)
If you really want to know how to calculate borrowing power, you’ll need to dig deeper in to income analysis. Click on the link that best matches your situation to learn more about how your income is analysed.
I’m self-employed I’m an employee (PAYG)
What’s the term assessable income mean when a lender calculates home loan serviceability?
Assessable income is the amount of income your lender is actually using in their calculation when assessing your borrowing power (home loan serviceability).
Your income may be crunched down (shaded), depending on your income type, your employment type, and the amount you’ve been getting paid in the last few months.
It’s influenced by your lenders opinion of that type of income.
Casual, Rental, Commission, Allowances or Bonus incomes are examples of income types that lenders like to shade.
Typically, your lender will have a fixed percentage for every type of income.
- Bonus income often accepted at 50% (but only if it can be verified as consistent for 1-2 years).
- Therefore bonus income earned for less than the minimum time would be allocated $0.
- Therefore, you might have 100% of your base income plus 50% of your bonus income added. This would then become your assessable income.
- Assessable income is your lenders calculation of your acceptable gross income.
- Lender will use their own credit policy to determine your assessable income.
- Depending on your income source/type, your lender may shade (reduce) your gross income for their assessment.
- The practice of shading income is widespread. If your income is significantly made up of rental, overtime, commission, bonus or some other allowance you might need to shop around to find the lender that suits you.
- If all your income is accepted to 100%, then your assessable income should equal your actual gross income.
By the way, not all lenders will shade in all situations, so talk to us if you’d like to know which lenders will shade your income.
Your lender will “pretend” your interest rate is much higher than it actually is…
Another factor when it comes to learning how to calculate borrowing power is the assessment rate. This is your actual interest rate, plus a margin.
This margin is added to stress test your borrowing power and to help insulate you from difficulties later on.
It’s the rate used for assessment of your ability to repay the loan, according to the lenders assessment criteria.
When calculating repayments on your mortgages, your lender will generally add around 2.5% to your interest rate. This buffer is used to ensure long term affordability.
- Assume your current interest rate is 4%.
- Lender adds 2.5%, your assessment rate would be at least 6.5%
- Most lenders also have a floor rate (minimum assessment rate, which could be higher than the above assessment rate – in which case the higher rate would be used).
The assessment rate reduces your borrowing capacity, but it’s a responsible lending practice to ensure you don’t get in to difficulty when rates go up.
How To Calculate Borrowing Power in 6 Steps…
When determining how to calculate borrowing power, you should extract each of these items separately.
Your lender will quickly seek to understand these specific questions, as it helps to determine what income can be used in the assessment.
1) What’s your employment type?
Are you permanent full-time or part-time, casual, contractor, self-employed, temporary, something else?
2) What’s your minimum income?
Employees, your base salary/wage excluding overtime, commissions, allowances, etc.
Self-employed, your Net Profit (before tax).
3) Is there any additional income or allowances you are paid?
Employees: Overtime, bonus, commission, car allowance, shift allowance or some other allowance? Is it paid to you as a condition of your employment? (ie. is it a permanent part of your pay?)
Self-employed: Are there any “add-backs” we can utilise within your tax returns? Depreciation, directors salaries, interest expense, one-off expenses, something else?
4) Any other investment income?
If so, what is it, how can we verify it?
- Rental income? What type of property and rental income is it? (Standard residential, holiday letting, commercial, etc)
- Investment income? You may require 2 years history to be acceptable
5) Any ongoing liabilities?
If so, what are they? (amount owed, repayments, remaining loan term)
6) What’s your cost of living?
You’ll need to estimate your ongoing monthly living expenses – things like utilities, insurances, household spending, etc.
Now that your lender has your income amount, the income type and your ongoing commitments, they can quickly assess your maximum borrowing power, based on those numbers.
If you do this yourself, it can help you get a fast start to see whether your goals are realistically aligned to the lenders borrowing capacity guidelines.
- Ask you lender what percentage of each income type they accept.
- Are you a tradie and paid via your ABN? If so, most lenders will want your tax returns for 2 years. Or;
- Are you relying on commission income? Do you need a lender to accept 100% of it?
- Maybe you have a company car, and you’re lender won’t boost your income?
There’s a million other examples of how employment length, income variations, and income stability could impact whether or not a lender accepts that income source.
For more information choose your situation below:
I’m self-employed I’m an employee (PAYG)
What to do if your bank says no…
Sometimes 9 out of 10 lenders will say no, but you might fit perfectly in to the one that you probably never would have found by yourself.
Talk to an expert now by booking a consult and get a demo on how to calculate borrowing power for your exact situation.