How Do Banks Assess Affordability?
by Carlisle Homes
Are you eligible for a home loan? Having a high income may not be enough to get you over the line. Here’s our guide to how banks assess your affordability-
When you apply for a home loan, the banks want to know that you can afford to pay it back. It isn’t enough to just show that you have a high income. The lender also assesses whether that income is sufficient to meet your mortgage repayments once living expenses are met.
Since the Banking Royal Commission, which handed down its findings in early 2019, banks have tightened up their affordability criteria. They used to use a standard expenditure measure known as HEM. Today, they look at your actual living expenses.
What this means for buyers is that even if you’ve bought property in the past, you should be aware that things might have changed. Obtaining finance isn’t as easy as it used to be.
Over the past few years, the ways in which lenders assess your ability to repay a home loan have changed. That means that even if you’ve successfully obtained a home loan in the past, you need to understand the current landscape.
One significant change is the way in which your spending is treated. Banks used to use standard measures to estimate your living expenses. Today, they look at your actual expenses and spending history. That makes it critical that you know what you spend ahead of time so that you can see if your loan application is realistic.
The Household Expenditure Measure vs real living expenses
The Household Expenditure Measure (HEM) is a standard benchmark developed by the Melbourne Institute in 2011. It estimates your living expenses based on a number of variables including income, family size, location and lifestyle.
This used to be the main measure used by lenders when assessing living expenses. However, it almost always underestimates real living expenses. This was identified as a problem in the Royal Commission’s findings. Since then, the Australian Prudential Regulation Authority (APRA) has brought in a requirement that lenders look at real expenditure.
They also look at more categories than before, including recreation, entertainment and travel. It used to be the case that lenders assumed borrowers would cut back on discretionary spending if they got the loan and found that their budget was tight. Now, they are required to assess affordability on the basis that the discretionary spending will continue.
If you’re listing living expenses, it’s very important to include everything. Many people forget, or underestimate, some of their expenses. These might be large but infrequent expenses, like annual members or private school fees. Or they might be those small discretionary spends that are so easy to underestimate, like eating out or catching an Uber.
Either way, if your bank statements tell a different story, it might raise a red flag. If they think that you are deliberately low balling your expenses, you may be considered a high-risk borrower.
Your lender will typically require at least three, and up to six, months’ worth of bank statements. To make sure that your assessment is accurate, it’s a good idea for you to go through those statements first and add up what you’ve really spent across every category.
If your statements don’t match your declared living expenses, you will need to explain why there is a discrepancy. For example, you might have had a medical crisis that is now over, or you were paying private school fees for a child who has since graduated.
How a mortgage broker can help
Mortgage brokers will go through your self-assessment with you before taking the loan application to the bank. Because they are experienced in loan applications, they know what the red flags might be. They also know what questions to ask to help you make the most accurate self-assessment.
If you do have a discrepancy, they will also work with you to help explain it in a way the lender can understand.