Sam and Jo are a WA couple looking to buy their second investment property.
Sam earns $132,000 a year and Jo earns $82,500, giving them a combined gross income of $214,500. They have two children (12 & 10), they own their home (with a mortgage) and already have one investment property.
Their own home is in the northern suburbs and is worth $1.5M. They owe $350,000 on their home.
Their existing investment property, in the southern suburbs is worth approximately $850,000 and produces rental income of $750 per week. They owe $400,000 on this property.
They are now considering purchasing a newly built investment property for $800,000, which is expected to rent for approximately $700 per week.
Allowing for the purchase and associated costs, Sam and Jo want to borrow an additional $850,000 which is the purchase price, plus costs.
So, can they borrow $850,000? The answer depends, largely on which lender assesses their application.
Borrowers can have very different borrowing capacities across different lenders.
We ran Sam and Jo’s circumstances through a range of lender servicing calculators. Their income, existing debts, rental income, family circumstances and proposed purchase remained exactly the same.
Their borrowing capacity across the lenders ranged from approximately $560,000 to $1.33 million.
Several lenders assessed Sam and Jo as being able to borrow the $850,000 they required. Many did not.
That’s a difference of more than $770,000 between the highest and lowest results.
Your borrowing capacity isn’t necessarily one number. An individual lender can tell you how much it is prepared to lend under its policies and servicing methodology. Another lender may reach a very different result.
Why do lenders reach different answers?
Each lender applies its own servicing methodology to Sam and Jo’s income, debts, rental income, household expenses and other commitments.
We can see the effect of some of those differences in their results.
Expenses
Each lender compares household expenses to their own benchmark known as the Household Expenditure Measure (HEM). The HEM amount used for Sam and Jo also varied between lenders.
There are also differences in how lenders treat rental income, existing debts and other financial commitments.
Those differences ultimately flow through to the amount each lender calculates that Sam and Jo can borrow.
Rental income doesn’t go into the calculation dollar for dollar
Rental income is particularly relevant when you’re building a property portfolio.
Sam and Jo’s existing investment property generates $750 per week in rent, while the proposed property is expected to generate $700 per week.
These rental amounts equate to combined gross annual rental income of $75,400. If a lender accepts 80%, that reduces to $60,320. Some lenders then deduct rental expenses, further reducing the amount of rental income available for servicing.
That’s more than $15,000 of income Sam and Jo receive, which may not be included in the lender’s servicing calculation.
As a portfolio grows, these differences become increasingly relevant because the borrower may have multiple investment loans and multiple sources of rental income being assessed at the same time.
Existing loans are assessed differently from the repayments you’re actually making
Sam and Jo currently make home loan repayments of $2,354 per month and investment loan repayments of $2,411 per month. The repayments on their proposed new investment loan would be $5,234 per month.
They know what these loans actually cost them each month, but those aren’t necessarily the repayments a lender uses when assessing their borrowing capacity.
Lenders apply their own assessment rates and servicing assumptions. For example, a loan with an interest rate of around 6% may be assessed using a rate of around 9%. This allows the lender to assess whether the borrower could continue to meet their commitments if interest rates increased.
In Sam and Jo’s case, this made a significant difference.
Their home loan repayment of $2,354 was assessed at $3,109.
Their existing investment loan repayment of $2,411 was assessed at $3,221.
Their proposed investment loan repayment of $5,234 was assessed at $6,993.
In total, Sam and Jo’s loan repayments (including the proposed investment loan) would be $9,999 per month, but for this servicing calculation the lender assessed them at $13,323 per month.
That’s a difference of $3,324 per month.
The assessment rate used can also vary between lenders, which is another reason two lenders can start with the same loans and repayments but arrive at different borrowing capacities.
The Credit Card
Sam and Jo also had a credit card with a limit of $15,000.
They pay it off every month, but lenders still apply repayments because they assume that the card could be drawn.
When we first looked at their borrowing capacity, we included the credit-card facility in their financial position.
We then ran the calculations again, assuming the credit card had been closed. The borrowing-capacity results changed.
Looking behind the numbers, most lenders in our comparison assumed a monthly commitment of 3.8% of the credit limit, or $570 per month. At the lower end, some used 3%, or $450 per month.
For one lender, maximum capacity increased from approximately $1.33 million to $1.52 million.
It would be misleading to conclude from this case study that closing a credit card will increase everyone’s borrowing capacity by a particular amount.
What the comparison demonstrates is that existing credit facilities can affect borrowing capacity, even when there is little or nothing owing on them. Different lenders can also assess their impact differently.
The highest borrowing capacity isn’t necessarily the best lending option
Sam and Jo need $850,000. A lender assessing their maximum capacity at $1.3 million isn’t necessarily more suitable than one assessing them at $900,000.
Interest rate, fees, loan structure, features, credit policy and the borrowers’ broader circumstances all need to be considered.
There is also an important distinction between borrowing capacity and affordability.
Borrowing capacity is an assessment of how much a lender may be prepared to lend under its credit policies and servicing methodology.
It isn’t a recommendation about how much Sam and Jo should borrow or whether buying the proposed investment property is appropriate for them. Those are different questions.
What does this mean if you approach one lender directly?
If Sam and Jo approached a lender that assessed their maximum borrowing capacity at $700,000, they would be $150,000 short of the amount they require and may conclude that they can’t make their investment purchase.
That lender’s assessment isn’t wrong. Under its servicing methodology, Sam and Jo don’t have sufficient borrowing capacity.
But another lender looking at exactly the same financial position may be prepared to lend the $850,000 they need.
The borrowing capacity provided by one lender is that lender’s assessment. It shouldn’t automatically be interpreted as your borrowing capacity across the lending market.
A note about this case study
The Sam and Jo case study has been constructed to demonstrate how borrowing-capacity calculations can differ between lenders.
The proposed investment property is assumed to be a newly built residential investment property. The figures are based on lender servicing calculations available at the time the scenario was prepared and are for illustrative purposes only.
Lending policies, interest rates, assessment rates and servicing methodologies change over time. Individual circumstances will also produce different results.
This article discusses lending considerations only. Tax treatment, property selection, ownership structure and investment strategy should be discussed with the appropriate professional advisers.
