When you apply for a home or investment property loan, your lender must obviously assess your ability to repay the loan (amongst many other criteria). Naturally, lenders will not lend to an applicant who can’t afford pay it back—and they’re also bound by strict governmental rules and regulations when assessing the suitability of potential borrowers.
The outcome of the lender’s assessment process defines what is called an applicant’s “mortgage serviceability”. The strength of your mortgage serviceability—or in other words, “your ability to repay the loan”—is a significant contributor to the strength of your overall application. Naturally, weaker serviceability may lead to your application being declined (because you are demonstrating higher risk to the lender).
In this article, I will explore how most banks calculate this important serviceability figure and provide other strategies for helping you strengthen your application. After all, if you understand what banks are looking for, you can ethically optimise your finances to present the best possible application.
How is serviceability calculated?
Mortgage serviceability is calculated by examining your desired loan amount, the repayment amount (based on how much of a deposit you have), your income, your expenses, your existing financial liabilities, and a handful of other factors. The most common metric for summarising serviceability is your “Net Service Ratio” or “Debt Service Ratio” metric, which demonstrates your monthly debt expenses as a percentage of your monthly income. Most Australian lenders set a maximum debt service ratio of roughly 30%, meaning no more than 30% of your monthly income should go towards paying off debt.
Here are the main factors of a mortgage serviceability calculation in more detail:
1. Your Income And Financial Behaviour
Your income (either individually or as a couple, depending on your application) is a significant determinant of a loan’s serviceability. Banks use your after-tax income as a baseline for their calculations, and may also include income from investments, second jobs, Centrelink, and up to 70-90% of rental income from investment properties. Some banks and non-bank lenders incorporate “overtime” wages as extra income, but this depends on the (a) the bank’s policies and (b) the nature of your occupation.
Banks will also need to see that you have demonstrated conservative financial behaviour. They usually require that you have a strong savings history and may be less inclined to approve your application if you gamble frequently, often withdraw money at casinos or make lots of cash withdrawals that can’t be accounted for. Nowadays, some lenders are looking for up to six months of bank statement history to see what applicants are really spending and saving each month.
Once your income has been defined, banks will then deduct:
2. Your Living Expenses
This is often the least understood but highest driver of loan disapprovals. Banks will deduct, at a monthly level, all of the expenses you need to live, including:
- Current loan and finance repayments
- Bills eg. power, Internet, water, car registrations
- School fees
- And any other regular outgoings
This may seem intrusive, but banks need to know how much money you have left at the end of the month *after* all of these expenses have been paid. This is another reason they may ask for up to six months of statements.
Once your living expenses have been deducted, banks will then assess:
3. Your Liabilities
Banks must include any existing loans, credit cards, finance agreements etc. when assessing your serviceability. Generally, they will assess your application as if every credit card and line of credit etc. you have were maxed out and you were required to make maximum monthly repayments (a rule of thumb is to pay 3% to 4% of the credit limit each month).
Any existing debt usually decreases the amount you can borrow. Credit card limits create the most significant reduction in new borrowing capacity (for many banks, having an existing credit card with a limit of $15k can reduce future borrowing capacity by up to $50k).
Banks will also ask about your dependents (eg. children). Each dependent may decrease future borrowing capacity by up to $50k.
4. Future Interest Rate Buffering
When assessing serviceability, banks usually add approximately 2.5% on top of your proposed loan’s interest rate, to ensure that you can make repayments if interest rates rise.
For example, if you apply for a loan offering an interest rate of 2.45%, the bank will assess your ability to pay it back on a rate of 4.95% (2.45+2.50) or their minimum “assessment rate”. This ensures that borrowers aren’t stretched if interest rate were to rise.
(It’s important to note that before July 2019, lenders would use a minimum assessment rate of around 7%, however this has been relaxed with some banks assessing as low as 4.95% along with the above 2.50% buffer rule).
5. Other Factors
There are other factors that may influence a bank or non-bank lender’s serviceability process including:
- Whether or not your loan is interest only, or interest and principal
- Factors unique to each bank or non-bank lender
How to increase your serviceability
Here are four strategies for increasing your serviceability:
- Reduce Your Expenses. This is a straightforward one—in the six-month period leading up to your loan application, do everything you can to spend less and save more. Lenders are going to review every line item in every bank statement over this period.
- Increase Income. This is also a straightforward one, but often harder to implement. Can you ask for a payrise? Can you create a secondary income stream? Think of smart ways to increase your income over this period.
- Reduce Existing Credit Limits, And Debt Overall. As I’ve already discussed, existing credit cards can severely decrease your serviceability. Consider paying off one (or more, or all) of your credit cards prior to your application.
- Put A Pre-Approval Strategy In Place, Six Months Prior. The best way to engineer your application for success is by putting a specific plan in place at least six months prior. The team at Trilogy specialise in helping investors and home owners with this “Pre-Approval Plan”…
Put a “pre-approval plan” in place six months before you apply
The quickest and easiest way to learn more about a successful pre-approval plan is to request a Free 30-Minute Finance Strategy Session during which you will…
- Get an up-to-date picture of the lending landscape including rates, conditions, and how to structure loans for cashflow positive investors
- Gain greater clarity over where you want to be in terms of owning investment properties (and how to structure your loans to get there the fastest, safest way)
- Discover how to unlock the equity in your current properties, so you can build your portfolio – and your wealth – faster (and enjoy a better lifestyle now and in retirement)
- Discover clever, no-cost ways to save money on interest, fees, and charges — immediately
- Learn about our process to find you a better loan that will save you thousands.
This no-obligation session will be held with one of our experienced mortgage brokers.
Please be assured this will not be a thinly disguised sales presentation. On the contrary, you’ll receive our best strategic advice, specific to your situation, so you too can accumulate multiple properties without sacrificing your current lifestyle and accelerate your progress towards wealth.
Please note, the numbers and assumptions listed in this article are for educational purposes only. Individuals should seek specific advice pertaining to their unique situation and the real estate market before making any decisions.
Trilogy Funding Two is a corporate credit representative (Representative Number 506131) of BLSSA Pty Ltd, ACN 117 651 760 (Australian Credit Licence 391237)