Rising interest rates stealthily reduce your borrowing capacity.
But, fortunately, there are a few simple things you can do to increase it.
I’ve talked about this a few times over the last couple of months. Not only do rising interest rates increase loan repayments, they also reduce your borrowing capacity because the so-called “serviceability test” increases.
This is where a lender must assess your ability to service a loan based on an interest rate 3 per cent above what you’re applying for.
In other words, the lender “stress tests” mortgage applications to make sure borrowers can still afford the repayments if rates rise 3 per cent above the current rate.
For example, someone earning the average wage in May 2022 has seen their maximum borrowing capacity plummet by $170,600 because of the hikes, assuming they haven’t had a pay rise in this time.
Historically there has been a cultural belief in Australia that home ownership leads to an improvement in living standards. Owning your own home is seen as a symbol of success and security, which leads people to think it is the best investment for the long term.
Since 1961, home ownership has been relatively stable at around 70 per cent, with a decline in recent years to 67 per cent due to stretched affordability. Home ownership tends to increase with age, alongside general increases in wealth.
However, analysis shows a rise in the proportion of renters, as buying a home becomes less affordable in all capital cities.
Even without the recent price rises, there are significant risks associated with taking on a large mortgage. These include interest rate risk and lack of investment diversification.
It is becoming a real issue for borrowers.
According to RateCity, there are a few easy ways to boost borrowing capacity.
Increase your income
Ask your boss for a pay rise, start a part-time second job or look for a side hustle to earn extra cash.
Look for a low rate
Banks stress test your finances on the rate you are applying for, plus an additional 3 per cent. So the lower your variable rate, the more you are likely to be able to borrow. Using a mortgage broker is a good way to do a quick check on your borrowing capacity across the lenders on their panel.
Spend less and save more
The bigger your deposit is, the less you’ll need to borrow, so turbocharge your savings strategy today. A larger deposit will also help minimise or even remove the need to pay lenders mortgage insurance.
Clean up your budget
Show your bank just how frugal you can be by cutting back on your discretionary spending now. Takeaway coffee, Uber Eats deliveries and multiple streaming services seem harmless but they are little luxuries that can go against you when you’re being assessed for a loan.
Close down credit card accounts
The banks have to assume you could max out your card, which can put a significant handbrake on how much you can borrow for your first home. The fewer credit cards the better.
Pay down other debts
Try to clear as much off these debts as you possibly can. Buy now, pay later spending can also raise eyebrows, so it’s best to steer clear of these platforms as well.
How much more could you potentially borrow?
RateCity has crunched the numbers to see how far a single person earning the average wage could potentially boost their borrowing power. The scenario is based on someone earning the average wage before the rate hikes who hasn’t had a pay rise since.
The person has a $10,000 credit card limit and is planning on applying for a big four bank basic variable loan with a 20 per cent deposit. They spend $2400 on essentials each month (not including housing costs).
If this person could: secure a 4.25 per cent pay rise, close their $10,000 credit card, switch to one of the lowest variable rates for someone with a 20 per cent deposit, and cut down their expenses by 25 per cent, they could potentially borrow an estimated $137,900 more from the bank.
These are all great tips, but make sure you don’t stretch yourself so far that it is unsustainable and you don’t have a financial buffer.
It is a time for cautious borrowing.
Information and opinions provided in this column are general in nature and have been prepared for educational purposes only. Always seek personal financial advice tailored to your specific needs before making financial and investment decisions.
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