It’s every home buyer’s first thought – how much should I borrow for a home loan?
The amount a lender may be willing to let you borrow isn’t always the amount you should borrow. It’s important to take into consideration all your personal finances before making a purchase decision as borrowing more than you may be able to afford to repay in the future can lead to a really bad financial outcome.
How much should you borrow for a home loan?
When taking out a home loan, everyone’s’ existing and future financial situations are going to be somewhat unique – so let’s first take a look at what the lending industry thinks before investigating the additional factors that are likely to be applicable to you as an individual.
The lending industry indirectly recommends that people not borrow more than 80% of the property value through the general application of policies which enforce that borrowers take out Lenders Mortgage Insurance, or LMI in order to be approved for a loan. Effectively, they are saying that buyers should have at least a 20% property deposit saved. A 20% deposit on a $450,000 house is $90,000!
Essentially, lenders are protecting themselves from a situation where:
- you’re unable to pay or ‘service’ the loan for an extended period of time (eg. you might lose your job and have no savings, you may get sick and be unable to work, etc.) AND
- the value of the property drops below what it was when you purchased it.
In this situation, they look to cover the worst case scenario of them having to re-possess the property and sell it to get back what they are owed.
If a 20% deposit isn’t an option, there are still a few ways that you can apply for a loan. The first option is taking out Lenders Mortgage Insurance. LMI can vary in price depending on the lender and what loan-to-value ratio (LVR) percentage you have.
The second option is when one of your family members acts as a guarantor. To be successful, the family member must be able to demonstrate either their own capacity to repay your loan and be willing to be liable for your home loan if you default on a payment or to put their own property equity forward as collateral. This is not something to be taken lightly, but is a valid option if you’re struggling to break into the home loan market and you can find a suitable guarantor who trusts in your capability and willingness to service your loan.
Getting a better idea of your financial capability: Five things to consider
No matter which path you take with your deposit and securing a loan approval, it’s essential to calculate your personal finances to give you a better idea of just how much you should (not ‘could’) borrow. Here are five things to consider before taking out a mortgage.
1. Household income
When assessing your finances, ask yourself what kind of lifestyle you want. Are you single? Married? Have a baby on the way? Do you like designer shoes or do you eat out regularly? Ask yourself if you’re willing to make sacrifices and if so, where are you going to reduce your spending? Your household income is one of the first things a lender will look at when determining if you’re eligible for a home loan. If you can show a record or budget of your spending habits per week, this can help prove you’ll be able to meet the repayments required.
2. Credit rating
A credit rating, or credit score, is the next thing a lender will look at to determine how much a risk you are as a borrower. Many people don’t ever check their credit rating and are surprised when their application gets refused. It’s a good habit to check your credit rating once a year to make sure you’re either on the right track or working towards improvement.
3. Property price and value
The next thing a lender will assess is the type of property you’re interested in and what purpose you’re buying the property for. Is it an investment property or are you looking to live in the home as an owner-occupier?
Another important thing to consider is the value or potential future value of the property you’re purchasing. Are you buying a house, apartment or land?
These questions will all have an impact on your borrowing power.
4. Home insurance
Home insurance is designed to protect your property from damage caused by events out of your control. As your home is your biggest investment, it’s important you ensure you’re able to afford home insurance before applying for a home loan.
5. Other costs
Similar to home insurance, there are a number of costs (both upfront and ongoing) associated with buying and owning a property. A few of these include stamp duty, LMI (if applicable), home loan establishment fees, legal and inspection costs, council rates, water utility rates and general property maintenance.
Buying a home is a big decision and should not be taken lightly. Assessing your borrowing capacity is just one of the ways to determine how much you can borrow for a home loan, but working out how much you should borrow will always be a personal decision based on a raft of other individual factors including how much risk you can tolerate and how much you are willing to sacrifice to ensure that you can make the most of your valuable property purchase.