A deeper understanding of your cash flow will help you avoid being stuck in a debt trap when you apply for a mortgage

If you are planning to apply for a mortgage, one of the most important things to find out is how much you can safely afford to borrow. The key word here is ‘safe’ - you need to know your threshold, which must not only be within your budget but will also allow for some breathing room.

Understanding your borrowing capacity

To know how much you can safely borrow, you need to understand the concept of borrowing capacity. Banks and lenders use this factor when determining how much an individual can actually borrow.

While there are multiple factors that can affect your borrowing capacity, your income is a crucial part of this.

With your income in mind, the banks will also assess what your lifestyle expenses are along with any liabilities you may have such as credit cards, personal loans, and other financial commitments.

Other factors that will affect your borrowing capacity include the mortgage term (or how long you are planning to pay for your loan), your age at application, and your retirement age.

Boosting your borrowing capacity

Borrowing capacity is something you can improve - there are tried and tested ways that can help you boost this borrowing power to ensure that you will get to borrow enough for your needs. Here are some ways you can widen your capacity:

Pay your existing debts

It is crucial for borrowers to look at their existing debts if they want to increase their borrowing capacity. Paying off personal debts is one of the most effective ways to boost your borrowing power.

Reduce your credit limit

One tip for borrowers with credit cards: Banks usually consider your credit limits as if you owe the amount in full. Reducing your credit card limit and paying them off quickly can help boost your borrowing power.

The criteria that lenders use varies, but generally, every $5,000 in credit card limits or personal debts you have reduces your borrowing power by up to $25,000 - that means $20,000 worth of personal debts could reduce your borrowing power by $100,000.

Provide proof of expected rental return

If you are going to rent out the property, the lender may also take into account the expected rental return and any applicable negative gearing benefits when determining your borrowing capacity.

If you are borrowing for an investment property, you might need to provide a rental letter from a real estate agent outlining the expected market rental return. If the property is already leased, you may be required to provide evidence of tenancy to the lender.

Some lenders may use the rental return estimated by the valuer over a rental letter so it’s important to know that not every lender looks at this in the same way.

Knowing how much is safe to borrow

Now that you understand your borrowing power, you can create a plan that will help you determine how much you can safely borrow.

Knowing how much you can afford to spend will be able to help you get a clearer understanding of your borrowing power before you even start looking around for your new home. This makes it essential for borrowers to have a plan.

You might be looking at homes around the $500,000 to $550,000 mark with a $50,000 deposit, only to discover you can only borrow $420,000 or, you might be putting limitations on yourself when really, you can afford to spend a little more.

This is especially true in today's market - being aware of how much you can borrow and crucially getting a pre-approval before you begin shopping for property will put you in a strong position. This will equip you to make offers and give sellers the confidence that you can afford to buy their property.

Step 1. Do your sums

You will need to get a good grasp of your financial circumstances. You can achieve this by looking at your net income and lifestyle expenses for at least six months.

Although lenders will use their own set of criteria to determine a safe borrowing limit for your home loan, it’s important that you cross-check this figure against your own budget to ensure you stay within comfortable levels.

You should never base your decision on a figure that someone else says you can afford. Some lenders may offer you a higher loan amount than you can comfortably and realistically afford based on your income.

However, it is very important that you complete a detailed forward budget to ensure you are comfortable with the repayments over the life of the loan. You should also build into your budget a small financial buffer for unforeseen circumstances and changes in lifestyle.

Going through lifestyle expenses can be quite confronting. However, it is better to go through these expenses prior to committing to a loan amount that will comprise your lifestyle. There also needs to be a consideration on what contingency funds you have should you have issues with your employment or unexpected expenses.

Step 2: Drawing up your budget

Our Borrowing Power Calculator can help give you an estimate of how much you can afford based on your income and expenses. This calculator can determine how much you can borrow under a certain interest rate and a loan term.

Here is an example: Let’s assume that you are a single home buyer with an annual salary before tax of $70,000 and expenses amounting to $2,800 monthly. For this example, let’s say you have a credit card with a credit limit of $9,000. You are planning to apply for a loan that has an interest rate of 2.5% for a loan term of 25 years. How much can you borrow under these circumstances?

With the given factors, our Borrowing Power Calculator shows that you can apply for a mortgage amounting to $200,000. This will have a monthly repayment of around $900.

While online calculators are not definitive, they could give you a good indication of the ballpark figures you can aim for when applying for a loan. Tools like online borrowing and repayment calculators and extra repayment estimates can really help you understand what your financial situation looks like now, and what it could look like in the future.

Step 3: Factor in costs and expenses

The most important thing about determining your borrowing capacity is knowing that you can maintain the month-to-month expenses in the long term.

When working out your budget, keep in mind what your future expenses will be once you have purchased a property so that you don’t find yourself out of your comfort zone at a later date.

As a homeowner, you will have to factor in the following costs (although this is by no means an exhaustive list):

  • council rates
  • body corporate fees
  • insurance costs
  • maintenance costs
  • utility bills
  • management costs (if you are buying an investment property)

It is also important to take into account what changes you may be expecting in your circumstances in the coming years and how these may affect your financial comfort with your repayments. You need to ask yourself the following questions:

  • Do I expect my income to increase in the coming years? (For example, you may have recently obtained qualifications that will boost your income)
  • Do I plan to have children and cut back on my work commitments?
  • Do I plan to retire in the short term?

Taking your expectations for the future into account may either give you greater comfort with your projected repayments or result in deciding to limit what you are willing to borrow. You don’t want to limit yourself unreasonably by borrowing less than you can comfortably afford and not getting the best property that you can. But there is no advantage in stretching yourself so far that the loan becomes unmanageable.

Step 4: Stay in control

Even if you’ve created a fool-proof budget plan for the long term, there may be things outside of your control that will put pressure on your finances and impact your ability to meet repayments.

Unforeseen illness or injury can often be the cause of financial hardship, so it’s important to consider protecting yourself and your family with the appropriate insurance. This may include income insurance, life insurance, or total disability and recovery insurance.

Many people have the “it won’t happen to me” mindset, but you never know what life will throw at you. With a little advice from a trusted planner or insurance broker, you can ensure you have planned for the bad times as well as the good and feel safe, knowing that you have protected your investment.

In short, the most important point to consider when taking on new lending is that you need to be financially comfortable with your monthly repayments. Purchasing a property requires careful planning. By taking responsibility for your borrowing through planning and budgeting, you prepare for the best outcome for yourself.

Reaching out to mortgage brokers

You do not have to do all this planning alone - mortgage brokers will be able to assist you in determining how much you can safely borrow.

With their industry knowledge and expertise, mortgage brokers can assist you in navigating the lending market and in understanding your financial overall financial health.

Mortgage brokers can provide a personalised service by understanding your current circumstances along with your requirements moving forward. They take the time to deep dive into your financials and will make a recommendation based on your lifestyle as opposed to your maximum borrowing capacity.