September 4, 2020
- What is loan serviceability?
- What is a loan serviceability assessment?
- How much does a loan serviceability assessment cost?
- How do lenders calculate serviceability?
- Calculating your personal borrowing power
- How do lenders assess my serviceability without knowing my preferred loan term or interest rate?
- How can you improve your borrowing power?
Loan serviceability describes your ability to meet your home loan repayments based on factors such as the borrower’s income and the size of the loan. Simply put, the lender is assessing your ability to pay back the requested loan.
When applying for a home loan, lenders will take a number of factors into consideration to determine what size loan you can service, or meet repayments on, and each lender has their own formula to calculate this.
By assessing the amount of the loan, the income of the borrower, as well as the borrower’s expenses and other commitments, the lender generates a figure known as the debt service ratio that describes the borrower’s monthly debt expenses as a proportion of their monthly income.
Loan serviceability can be improved if your debt service ratio doesn’t fit the needs for your loan.
A serviceability assessment is one of the first steps of the loan application process, occurring before the lender performs a credit check. This is the name given to the process of considering the relevant factors that affect the borrower’s financial situation to determine their loan serviceability and debt service ratio.
A serviceability calculation is derived by taking a borrower’s income, less expenses, household expenditure, and the new loan repayment.
A further point about the assessment of serviceability is that lenders may add a buffer to the assessment rate in order to ensure the applicant will be able to keep up with repayments should interest rates rise.
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A loan serviceability assessment won’t cost you anything as it is simply part of the checks and processes your lender will undertake when considering you loan application, similar to conducting a credit check.
Put simply your loan serviceability is calculated by subtracting your financial obligations from your income to determine the repayment amount you can comfortably meet. However different lenders will take different factors into consideration when calculating serviceability, meaning how much you can borrow can be highly dependent on your choice of lender. While income is the primary factor, lenders can also take into account overtime, commission payments, company cars, investment properties, welfare payments, dependents, and much more.
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Income is the primary factor that will influence serviceability, but this can come from a variety of places that include:
- Salary or income from employment, including secondary employment
- Rental income
- Welfare benefits, such as Centrelink benefits and in particular Family Tax Benefits Part A and B
Serviceability assessments are more nuanced than a simple calculation of income minus expenditure and each of the above factors can affect a borrower’s application to a different degree based on their individual circumstances.
Next your lender will consider any liabilities or financial obligations that you are already committed to paying, generally in the form of debt from other loans. The lender will also add a buffer into their calculations to allow for rising interest rates and to ensure you can meet your repayments. This means that as a general rule lenders set a maximum debt service ratio of between 30 and 35% of the borrowers income.
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Your lender will also take your personal circumstances into consideration when calculating your borrowing power. For example, emergency service sector workers, like police, firemen, nurses and other healthcare workers, are considered more likely to rely on overtime pay and so the lender will often take this additional salary into more account than they would where overtime work is more sporadic.
This is where using a brokerage service can help you determine the lenders offering the highest serviceability calculation for your situation, or those offering the terms most important to your loan.
Until recently lenders assessed home loan applications with a default minimum interest rate of 7%, with common industry practice applying a rate of 7.25% to applications, a number significantly higher than current interest rates.
The Australian Prudential Regulation Authority (APRA) has recently given lending institutions the power to determine their own minimum interest rate for serviceability assessments. Lenders are not required to advertise their chosen assessment rates which typically range anywhere from 5 8%, which can make it easy for applicants to fail the serviceability test.
However, the changes to the default 7% serviceability rate means mortgagees seeking a loan based on current low interest rates may see an increase in borrowing power of 15% for first home buyers and as much as 30% for investors.
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Serviceability can be improved to increase your borrowing power and achieve your property goals by either increasing your income or decreasing your expenditure or liabilities.
There are ways you can improve your serviceability to increase your borrowing power if your assessment returns results lower than you were hoping for.
- Reduce credit liability. Many people assume that as long as they meet their monthly repayments on credit cards they don’t pose any threat to their borrowing power, but lenders will assume available credit lines are a potential risk. Assess any credit cards, and particularly any that aren’t being used, and get rid of them, while also actively working to reduce any credit debt you have accrued.
- Consolidate existing debt. If you do have multiple credit cards with outstanding balances look into consolidating these into your mortgage loan to avoid costly monthly repayments from high interest loans which will negatively impact your serviceability.
- Provide accurate information in your loan application. Depending on the structure of your income, such as if you typically receive bonuses throughout the year, providing the standard two recent payslips may not be an accurate representation of your income. Keeping up with your tax returns will mean the lender can also seek a comprehensive payment summary from the ATO that can enhance your serviceability.
- Share the load of liabilities. Although a loan might be taken out in your name if you plan on sharing the financial burden with a partner or family member, proving this to the lender might strengthen your borrowing power.
- Consider a longer loan term. Most lenders will allow a maximum loan term of 30 years on a mortgage, although this might be flexible for the right candidate. Extending the lifetime of the loan will reduce the amount of each individual repayment and make repayments more manageable for borrowers. However, it’s important to remember that increasing the loan term will also mean increasing the overall interest and fees that you’ll pay on the loan overall. It’s worth considering what is more important to you in the case of lengthening the loan term.
- Save more equity. Although taking the time to save a higher amount of equity is not an option for every borrower, having a larger deposit when applying for a loan will increase your serviceability by decreasing your loan obligations.
Words by Danielle Austin
Written by Refinancing.com.au
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