Securing a home loan offer is an exciting moment. A world of possibility opens around that all-important number.
And while no one wants to rain on the parade of eager house hunters, there’s a key question to address before falling in love with a property: Is there a difference between what you can borrow and what you should borrow?
Only 10 per cent of borrowers take the maximum amount lenders are willing to offer, according to the Reserve Bank of Australia.* So, despite burgeoning debt levels, we’re still a relatively sensible lot.
However, this year, with economists speculating we’re at or near the top of the rate cycle, more borrowers may be tempted to extend themselves as they’re squeezed between rising prices and falling borrowing capacity.
Since the RBA began hiking the target cash rate in May 2022, the amount average home buyers can borrow has fallen 30 per cent.** That equates to a drop in purchasing power from $878,400 to just $600,300 for an average family of four, according to Rate City analysis.
During the same period, the median home value in Australia has grown by 10 per cent to $762,000.***
Little wonder many borrowers may find themselves weighing up the pros and cons of taking on a larger loan to meet the market in 2024. Working out your financial comfort zone involves considering several factors.
Understand how loans are assessed
No one – especially brokers and lenders – want to see borrowers in over their heads. The first step in deciding what size loan to take on is understanding how lenders assess it. Your broker will step you through this in detail, but in a nutshell, lenders deduct your living expenses and total debt repayments (including outstanding HECS debt repayments and ~3 per cent of credit card limits) from your income, with a buffer for potential interest rate rises.
Interest rates
Pay attention to the rate cycle.
No one has a crystal ball, but we do have history. With rates at historic lows in late 2020, most realised the only way was up. It was just the speed and scale of hikes that few predicted.
To insulate against such shocks, APRA requires banks to use a serviceability buffer to stress-test loan applications.
Since October 2021, the buffer has been set at three per cent. Home buyers borrowing at 6.5 per cent today would need to prove they can cover repayments at 9.5 per cent. Some argue this is too high, given a three per cent hike is very unlikely.
Equally, others point out it has been too low in the past, as those assessed on the same three per cent buffer in late 2021 have since experienced rate rises totalling more than four per cent.
Future focus
Consider how much wriggle room you want to build in for unexpected (or even expected) events such as children, travel, education or job loss. Or if you see nothing but years of hard work, promotions and pay rises ahead, you may be comfortable borrowing towards the higher end of your capacity.
While the bean counters will examine your finances, only you know what you need from life to live happily.
What is mortgage stress?
Mortgage stress is considered to kick in when home repayments total more than 30 per cent of a household’s pre-tax income. It’s not a hard and fast rule as many people on high incomes can still live comfortably at this ratio. But it’s a good indication of where things might start to get uncomfortable.
Another way to look at things is debt-to-income ratio. The Australian Prudential Regulation Authority (APRA), the Government body that oversees the financial sector, considers loans more than six times household income to be risky.****
* Kearns, J, Interest Rates and the Property Market, speech to AFR Property Summit, 19 September 2022.
** Hannam, P, Australian property market may soon cool as rate hikes shrink borrowing capacity, The Guardian, 10 November, 2023.
*** PropTrak Home Price Index, www.proptrack.com.au/home-price-index
**** APRA, APRA increases banks’ loan serviceability expectations to counter rising risks in home lending, www.apra.gov.au, 6 October 2021.
Case study
Aleisha and Michael
Ipswich, Queensland
First-home buyer Aleisha admits Googling million-dollar homes, imagining what life could be like when she and her partner Michael were told they could qualify for a loan of up to $950,000 in 2020.
“Who wouldn’t?’’ she says. “The thought of having our dream home first up; never having to move again.”
It was tempting, but the 25-year-old thanks her lucky stars (and her economist mum) that she followed a lifelong habit of hoping for the best but planning for the worst.
Rather than maxing out their borrowing, Aleisha and Michael opted for a much more conservative loan to buy a $440,000 four-bedroom, two-bathroom home in Ipswich, Queensland.
At the time, the fixed interest rate on offer was 2.14 per cent and many thought low interest rates were here to stay. Not Aleisha.
“I looked at historical interest rates and noticed they had a mean of about 7 per cent when you took out the major highs and lows.
So, I thought, okay, the worst-case scenario is going to be 7 per cent. I want to make sure that if the interest rates do get to that level, we’ll still be comfortable. And if I’m overthinking it, well then at least we’re sitting pretty.”
As it turned out, Aleisha’s war-gaming of interest rates was spot on, with the couple’s mortgage due to roll off at a rate of 7.85 per cent last year (although they were able to refinance to 5.7 per cent).
Had they over-extended themselves, they may have been forced to sell, says Aleisha, something she has watched friends do as repayments skyrocketed.
Although Aleisha and Michael don’t yet have their forever home, she’s glad they jumped into the market when they did. Within two months their house valuation had jumped $50,000 and now sits around $680,000.
