Many factors come into play when applying for home loans, and home loan serviceability is arguably one of the most important aspects in the process.
Learning what home loan serviceability is before applying for a home loan can be highly beneficial.
Once you understand what it is, you can work towards making your application more attractive to lenders.
As a result, this gives you a better chance of actually being approved for your loan on the first try.
What Is Loan Serviceability?
Applying for a home loan is quite a lengthy process and often, property buyers prefer to use the services of a mortgage broker to assist them with this process.
A home loan serviceability assessment is one of the steps you have to go through when applying.
Lenders have to take into account certain aspects of your financial situation to decide whether you are able to afford the home loan you are seeking.
Checking your home loan serviceability means determining if you’ll be able to afford the loan based on:
- your income;
- your expenses;
- the loan amount.
- your savings; and
- your credit history.
Therefore, home loan serviceability refers to your ability to pay (or ability to service) the loan amount over its entire term. A loan serviceability assessment delves deeper into these factors.
1) How Lenders Assess Your Income to Calculate Your Home Loan Serviceability
- have a regular job with a steady income; your salary will be considered in its entirety eg. full time, part time..
- have a second job, such as a casual job, this income will only be considered if it’s consistent and has been employed for 6 months with the same employer.
- receive rental income, majority of the lenders will only consider 80% of what is received
- receive income from investments; has to be consistent over at least 2 years.
- receive overtime pay; most lenders consider this at a reduced rate because it’s inconsistent, and work conditions could change. However, If you work in the police, fire service, or health sector, there is a high chance banks will consider your overtime in full.
As a borrower, you want your income to be as high as possible and your expenses as low as possible. Unfortunately, your home loan serviceability income might be much less than what you perceived it to be due to these considerations.
You can try to maximise your income. By obtaining a part-time job, however, at times it’s worth waiting a certain period of time year before applying so that income can be considered, especially when borrowing above 80%.
2) How Lenders Assess Your Expenses to Calculate Your Loan Serviceability
A bank will at times scrutinise every last detail of your expenses – this is from the back of the Royal Commission.
They would prefer to cut their losses and rather not approve your home loan application if they see certain spending behaviour they deem risky.
Various taxes and contributions get deducted from your gross income every month, leaving you with your net income. This could be:
- Existing Debt
- Insurance; and
- Other essential and non-essential expenses (such as recreation).
The money remaining (if any) is called discretionary income or surplus. This “left-over” money is generally used for savings and/or investments.
Loan assessors will analyse your expenses to determine your surplus income. The fewer expenses you have, the larger your surplus income will be.
- If you decide to apply for a home loan, it’s worth cutting down on your non-essential expenses for at least three months to bring that average down, such as going out to eat and drink, buying clothes and more
- Try and clean up your digital footprint. The clearer your record, the better. Try and settle your existing debt as soon as possible. It’s most beneficial, to begin with, the debt accruing the most interest
- Take into account your credit card and its set limit. Lenders don’t look at how much of the credit you have used – they consider the maximum spending limit of every card and factor that in as an expense. Even though you haven’t yet used (or might never use) the maximum amount on a credit card, a bank will consider the possibility
- Be sure to close unnecessary credit cards. Cap the spending limit of the credit card you do need to be as low as possible.
3) How Lenders Assess Your Income Versus Your Expenses to Calculate Your Loan Serviceability
Once a bank has calculated your considered income, as well as your considered expenses, there are three different ways they might calculate your surplus.
Then they will be able to determine whether you have enough surplus money to afford the monthly repayments of the home loan amount you want to apply for.
Net Surplus Ratio (NSR)
The NSR calculation takes your net income and subtracts your total monthly considered living expenses.
This amount is then divided by your current debt and the monthly payment amount of the home loan you want to apply for.
(Net income – Total monthly expenses) ÷ New and existing debts
If the ratio is 1:1, you have exactly enough money to cover the new loan. If the ratio is 1:1.40, it means you can afford 40% of your monthly expenses using your surplus. Each lenders have their own criteria, but generally are all within the same level.
You need to have at least some money left over at the end of the month in case of an emergency.
If your net income is $3,375 and your monthly expenses are $1,000, the balance deduction is $2,375.
This $2,375 is then divided by your new and existing debts ($2000).
The ratio is then 1:1.18, meaning you can cover your loan payments and have money left over at the end of the month too.
Uncommitted Monthly Income (UMI) / Monthly Surplus
The UMI calculation takes your gross income before tax and subtracts your total monthly considered living expenses, including tax, and includes the monthly payment amount of the loan you want to apply for.
Gross income – (Tax + total monthly expenses + new and existing debts)
The resulting deduction is your monthly surplus in dollars. The higher your surplus is, the better the chance that your loan will be approved.
$5,000 – ($931.67 + $1,000 + $2,000) = $1,068.33
Debt Service Ratio (DSR)
The DSR calculates your monthly payment amount of the loan you want to apply for, divided by your gross income before tax.
New debt ÷ Gross income
Generally it is unlikely that lenders will approve your loan if your DSR is too high, however each bank has their own policy.
$2.500 ÷ $7000 = 0.35714
0.35714 x 100 = 35.72%
Don’t Forget That Banks Add a Buffer to Your Loan Serviceability
The Australian Prudential Regulation Authority (APRA) insists that banks lend responsibly. To exercise caution, banks build a margin when calculating home loan serviceability.
An “assessment rate” of 2-3% higher than the market rate is used to calculate the loan repayments. This is to leave room for market fluctuations. Banks need assurance that you can afford not only your loan repayments now but your loan repayments a few years down the line when they increase.
Many people get declined when applying for home loans and don’t know why. They might apply over and over, making the same mistakes time and time again.
Understanding how banks consider your income for home loans is crucial – understanding how banks consider your expenses is crucial too.
Even more valuable is using this knowledge to optimise your finances before applying.
A mortgage broker will be able to assist you with calculating and assessing your ability to meet the bank’s criteria for loan serviceability, to give you the best chance of success in applying for the best home loans.
If you would like assistance in assessing your ability to borrow with your home loan serviceability, contact The Mortgage Agency today. One of our friendly team members can answer all your questions regarding investment property and applying for home loans, specific to your financial situation or needs.
Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to property buyers and investors. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal, tax or investment advice. You should, where necessary, seek your own advice for any legal, tax or investment issues raised in your affairs.