Serviceability – what is it and how do banks calculate it?

Are you wondering what your serviceability is and how banks calculate it?

When taking out a loan, the amount your bank will lend you will depend on a few things.

Along with your deposit, they also look at your “serviceability."

So what does serviceability mean, and why is it so important?

Broadly defined, serviceability is the ability of a borrower to meet loan repayments, based upon the loan amount, the borrower’s income, expenses and other commitments.

This generates an overall figure, known as the debt service ratio – a borrower’s monthly debt expenses as a proportion of monthly income.

Note: Most lenders set a maximum debt service ratio of between 30 and 35 per cent.

At the end of last year, there was talk about introducing new serviceability laws, which could mean potential borrowers have access to more funds.

Having a basic knowledge of how serviceability is calculated can help people understand and, if necessary, rework their finances in preparation for obtaining a loan for the purchase of owner-occupied or investment property.

So, how is serviceability calculated?

Income

When determining your ability to service a home loan, banks will take your after-tax income and subtract expenses and any other liabilities, such as credit card debt or money owed on another loan.

Banks will also add a buffer to your home loan interest rate to allow for any future interest rate hikes.

Before July 2019, lenders would use a minimum interest rate of at least 7%.

But with falling interest rates, this was deemed needlessly high and was amended to reflect the current interest rate environment better.

Nowadays, lenders are advised to add a margin of at least 2.5% to a loan’s rate to assess your serviceability.

That means if you sign up for a $500,000 loan with an interest rate of 2.5% p.a., you’ll be assessed on your ability to pay off that same loan at a higher rate (around 5%.)

Your lender will look at your income can include regular salary, overtime, shift allowance, bonuses and commissions.

In some industries such as police, fire services and nursing, overtime is an integral part of income and is considered in full for serviceability purposes.

Meanwhile, for other professions, a reduced proportion of overtime income is used.

In these cases, the lender acknowledges that the borrower has in fact been paid all of the overtime, but will only apply a reduced amount in calculating serviceability because there is no guarantee that the borrower will continue to earn overtime at the same level of market or employment conditions change.

If an applicant has a second job, the income from it will only be considered if the job has been held continuously for at least one year.

Note: Centrelink benefits, in particular Family Tax Benefit Parts A and B, are considered in most cases where the children are under the age of eleven.

Lenders take into account rental income from investment properties when calculating serviceability.

However, most banks will only use 75% of rental income.

The reasoning for this is that there are costs associated with owning a rental property such as maintenance, management fees and re-letting fees when a tenant vacates.

If an investment property is rented at $1,200.00 per month, 75% of this rental income which is able to be used for serviceability is $900.00.

However, there are a few lenders whose credit policies will use 80, 90 or even 100% of the rent.

Liabilities

On the other side of the equation are liabilities.

Existing debt or potential debt (by way of credit cards or lines of credit that are already in place) will lower the amount that is able to be borrowed for a new loan.

In the case of credit cards, most lenders will calculate a minimum repayment obligation of 2.5 – 3.0% of the approved credit limit.

Note: The lender may require evidence of this debt in the form of account statements in order to confirm monthly repayments.

This applies if there is a balance owing and even where there is a nil balance.

The reasoning for this is that the credit can be accessed to its limit at any time.

For example, if the account has a limit of $15,000, the minimum monthly repayment at 3% will be $450.

Having a $15,000 limit in place will reduce further borrowing capacity for a home loan by approximately $60,000.

Given the significant impact that credit cards can have on applications for new loans, it is advisable to reduce the credit limit(s) to an absolute minimum and cancel unused cards to improve borrowing power.

Similarly, a line of credit will be taken into account as if it were fully drawn down, even if it isn’t.

In addition, commitments to repaying a car loan, personal loan, HECS and rent will affect home loan borrowing capacity.

The number of dependents a person or couple may have also influenced a loan application since there is a financial commitment involved in raising children or caring for other dependents.

Typically, each dependent will reduce the amount able to be borrowed by between $40,000 and $60,000.

Other factors

Whilst many property investors receive tax benefits if their loan is negatively geared, some lenders will not consider this when calculating serviceability.

In calculating repayments for a new loan, lenders will add a margin to the variable rate, to arrive at what is known as the ‘assessment rate’.

Note: Today this margin is around 2.5% or more.

In other words, the banks want to know if you could repay your debts if interest rates reach 7.5% or 8%.

To make things worse, they also calculate your repayments at a higher rate as if you have a Principal & Interest loan, even if you have an interest-only loan.

Now you can see why it's harder to get finance nowadays - you may have affordability but still not meet the bank's more strict serviceability criteria.

Note: APRA insists that lenders have a duty of care to ensure that a borrower can meet loan repayments.

Lenders’ serviceability calculators can produce quite different outcomes and so an experienced mortgage broker provides valuable assistance in helping to determine which lender is most suited to each individual circumstance.

When I sit down with clients at Metropole and help them formulate a strategic property plan to secure their future, I always involve a proficient finance strategist to guide them through the maze of banks, finance and money.

About Brett Warren Brett Warren is National Director of Metropole Properties and uses his two decades of property investment experience to advise clients how to grow, protect and pass on their wealth through strategic property advice.