Many novice investors make a simple mistake when they first start out.
And that’s because they don’t understand the difference between their borrowing capacity and their affordability.
So I’d like to clear up this issue to help investors manage their cash flow better in the future and to help them on their path to success.
Simplistically, when you borrow money, the bank or lender has a responsibility to ensure you have the financial capacity to service the mortgage repayments now and into the future.
Of course, no one can predict the future because issues will come up from time to time, however the bank will assess your borrowing capacity on the basis of your current financial situation, as well as factor in a buffer in case interest rates were to rise.
It’s a way of stress testing your capacity to service the debt now and in the years to come.
What is your borrowing capacity?
The bank works out your borrowing capacity by using what’s called an “assessment rate”.
Each bank and lender has their own assessment rate and it’s based on the bank’s own appetite for risk, which is why your borrowing capacity can vary significantly from one lender to another.
On top of the assessment rate, the bank will also apply certain other factors and will load your existing (other) loans by a buffer, they account for all your incomes including wages and rental income(s), and they also include the limits on all of your credit cards.
The lender will also account for the number of financial dependants you have in your household, and apply a cost of living, which is the living amount used by the bank and may or may not be the same as what you and your household actually spends.
It can be more and it can be less and this is where the issue of affordability raises its head.
What is your affordability?
On the other hand, your affordability has more to do with your lifestyle and the choices that you make daily.
The choices you make and how you spend your money will differ to the person next to you and therefore the cost of living that the bank uses to determine your borrowing capacity seldom matches your actual spending pattern.
Of course, this is because your lifestyle is unique to you.
When you take on debt, you have a responsibility to ensure that you are not going over your head and that you know your numbers.
As the saying goes, if you fail to plan, you plan to fail!
So, before you take out a mortgage or any other type of debt, follow these simple rules:
1) Work out your current disposable income before the new debt is factored in.
2) Know what the new loan repayments will be and ensure there is adequate cash flow from your disposable household income that can easily meet the repayments.
3) Know your current cash flows (money in and money out).
4) Know the interest rate which the new loan repayments are based on, then calculate how much the repayments would increase by if your interest rate increased.
5) Is the debt you are taking on worth the hassle and risk? What is it that you are financing? A holiday? A car? Or is it an asset that will appreciate in value over time and will in fact add to your wealth in the long run (such as a property)?
It’s important to not be overly conservative and have some faith because, in the end, borrowing money is a key ingredient to creating wealth over the long-term.
It’s equally as important to be smart about it and only take on debt that you know you have the financial capacity to service now and in the years to come.
Borrowing money is not the issue, it’s not having the cash flow to service the debt, which is where some people run into trouble.
Having a safe financial buffer for unforeseen circumstances is also a great strategy, particularly for investors.
When it’s all said and done, it boils down to this: Serviceability is the bank’s responsibility and affordability is yours.
Lenders work out your borrowing capacity to ensure you have the capacity to meet the loan repayments and your job is to ensure that you have the financial means to meet the commitments for the new debt that you plan to take on.
So what this means is that in the beginning, before you even start on your property investment journey, you must completely understand the amount of money you can borrow as well as the amount of money you can actually afford.
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Michael Yardney is a director of Metropole Property Strategists, which creates wealth for its clients through independent, unbiased property advice and advocacy. He is a best-selling author, one of Australia’s leading experts in wealth creation through property and writes the Property Update blog.