I was talking to a client the other day about their borrowing capacity.
After I had put some figures into a series of calculators, we came up with a figure, which was somewhat larger than my client had thought possible.
The response was “Oh wow, so I can afford that much?”
Right then I knew I had to point out that this was just the figure that the bank’s calculator came up with. This is called your “Servicing” or Borrowing capacity. Affordability is another thing altogether.
Let’s look at Serviceability first.
When you borrow money, the bank has a responsibility to make sure that you are going to be able to cope with possible interest rate increases in the future. It does this by assessing your income using a higher than normal interest rate called an “Assessment Rate”. Each bank has its own assessment rate and it’s based on the bank’s appetite for risk. Assessing your serviceability in this manner is known as stress testing.
Along with the assessment rate, the bank will also apply certain factors to your existing mortgage loans, rental income and any credit card debt. Your rental income will be reduced by 20 to 25% to allow for vacancies, your credit card debt will be assessed as though your cards are all up to their limits, rather than their current balances, and any other existing debt is assessed at the assessment rate (not the actual rate). The bank will also assume that you have a certain lifestyle and factor in the living expenses based on the number of adults and children in the household. This nominal amount may or may not be equal to your actual cost of living. All of this is aimed at helping them to be certain that you can meet your future obligations and it all has a big safety margin built into it by them.
Over and above this stress testing the Bank will apply various “weightings” to each part of the application. Different weightings apply to different parts of the application and each bank has its own criteria for these weightings. Naturally, they keep this all confidential. This is called Credit Scoring and is used directly for assessment purposes.
Affordability relates to whether or not the loan will impact on your lifestyle. According to the dictionary, affordability is believing something is within one’s financial means. The extent to which something is affordable as measured by its cost relative to the amount that the purchaser is able to pay.
It comes down to whether you have the surplus funds available to meet this new commitment without it having a negative impact on your lifestyle. Naturally, only you know that.
Let’s say you are renting at the moment and easily meeting these rental payments each month. You’ve decided to buy a house to live in and the monthly repayments are less than the rent. At first glance it appears that you can afford the loan however it’s important to factor in the Council rates, Body Corporate fees if it’s a unit, as well as the compulsory Building and Contents insurance. I suggest you definitely do a budget to be are clear on your actual costs when you apply for a loan. A simple way to work out if something is affordable is to compare the cost to your current savings per month. Is it more or less?
If you aren’t saving anything at the moment then there is a bigger question to ask I think.
Your lifestyle is unique to you as well. How many times you go out, where you go on holidays, the type of meals you eat, hobbies you have and sport you play is as individual as you are. While the bank will allocate a certain amount in their serviceability assumptions, in reality only you know whether you can cope with the extra commitment and whether it will change your lifestyle.
When it is all said and done, it boils down to this. Serviceability is the bank’s responsibility and Affordability is yours.
If you have any questions on the different aspects of serviceability vs affordability or any other aspect of mortgage finance, please feel free to contact me at email@example.com