Most people believe that if the banks deem you worthy of a loan for a certain amount of money, then you can logically afford to take them up on their offer.
After all, the banks would not expose themselves to unnecessary risk by giving you more than what you can realistically pay them back, right?
However, that $500,000 loan which your lender believes you can service on paper may actually be unaffordable in the real, tangible world of household bills, living expenses and mortgage repayments.
You see…there is a distinct difference between the concepts of “serviceability” and “affordability” – with the former being what the bank determines you can manage according to their in-house calculators and loan assessment process and the latter being what you can actually manage according to your personal circumstances.
How the bank sees it
When I sit down with a client, generally the first question they ask is, “How much can I borrow?”
Often they will already be prepared for a ballpark response, having plugged some figures into one of the many online loan calculators now available.
Some clients are even pleasantly surprised to find the assessment tool they used suggested they could borrow far more than they ever dreamt they could afford.
But herein lies the issue.
While the banks’ lending calculators are a great way to work out how much you might be able to access via a loan, they all work on different principles and at the end of the day, will not necessarily provide an accurate figure when it comes to what you can truly manage in terms of those monthly repayments.
These calculators are intended as a stress test in determining your ability to service the loan at different interest rates, and work on the premise that it costs X amount to run a household, with the X amount applied depending on what your household looks like.
For instance, your serviceability will decrease if you have children; the more children you have, the less the banks believe you can afford, because it costs money to feed, clothe and provide for each of them on a daily basis.
Likewise, if you have credit cards with large limits, loans for consumer goods such as cars, or hire purchase contracts in place that require some type of monthly financial commitment, your serviceability will be impacted according to how much the bank thinks it costs to maintain these liabilities.
Essentially, lenders assess your “serviceability” by attributing an amount that they believe it costs the average family to live using something called the Henderson Index, which is like a standard industry barometer of household spending.
They plug in how much you earn, how much they believe you are required to spend each month according to your household composition and your total liabilities and then the calculator spits out a number that suggests how much you can borrow.
Depending on your income, that might be $200k or $2million, but the bottom line is, can you realistically afford it?
How a broker sees it
Of course all of these calculations are based on the banks’ perception of what it costs the average family to live.
However, the reality is often quite different.
An experienced, professional broker or lender will sit with you and work through a comprehensive budget to determine what you can actually afford.
This is a process that I would urge every would-be borrower to undertake, in order to assess your affordability; what loan amount can you realistically commit to without finding yourself in future financial strife?
So when a client asks me what they can borrow, I respond with a question of my own – what can you afford to borrow?
Thus begins the delicate balancing act of demonstrating to the client that, whilst the bank might suggest you can borrow X amount; here is what it will actually cost you in the long run.
Often at this stage clients come to the realization that, although I can borrow that much, I cannot necessarily afford it when it comes to maintaining my family’s current lifestyle.
This “reality check” involves clients completing an extensive fact find and budget that gives us a comprehensive insight into not only their standard living costs, such as weekly grocery and utility bills, but also discretionary household spending.
Let’s face it, most of us enjoy weekend outings with the kids, going to the odd movie here or there and perhaps a nice dinner and bottle of wine occasionally – this is the discretionary spending that is often overlooked when it comes to “serviceability” assessments as opposed to “affordability”.
The question is; would you be prepared to sacrifice any or all of those discretionary expenses in order to meet your monthly loan obligations?
All of these considerations are critical for home buyers and property investors to take on board, particularly given the current low interest rate environment that has seen an increase in the number of clients we have approaching us asking that big question – how much can I borrow?
The fact is, interest rates will inevitably go up again and no one wants to be caught short when that happens.
So the more important question you need to ask yourself before committing to any type of loan right now is, how much can you afford?
You should always aim to get that balance right.