When applying for a home loan, lenders typically use the Household Expenditure Measure (HEM) as a tool to analyse whether your financial health is sound enough to handle mortgage repayments.

In simplest terms, HEM is a figure that represents an overview of household expenses, which can help banks determine whether you can afford to add another cost to your budget.

Over the past years, the use of HEM as a benchmarking tool has been controversial, as it could underestimate the actual living expenses of home loan applicants, which could potentially affect their financial health in the long run.

But what does HEM mean and how do banks use it?

What is the Household Expenditure Measure?

HEM is a standard benchmark used by Australian lenders to assess a household's basic living expenses, playing a crucial role in determining an individual's borrowing capacity for home loans.

Overall, HEM is a value that represents the average annual spending by households. According to the Australian Bureau of Statistics (ABS), household expenditures are classified as absolute basics, discretionary basics, and non-basics. HEM classifies for than 600 household expenditure items under these three categories.

HEM reflects the median spend on absolute basics on top of the 25th percentile spend on discretionary basics.

How is HEM used?

When you apply for a home loan, lenders require you to declare your living expenses. They will also consider your actual living expenses by analysing transaction details from your bank account or credit card.

Your lender will then match you to a corresponding HEM category and assess your declared and actual living expenses to know your capacity to repay the loan. Take note that HEM is based on generic factors like location, number of children, marital status, and lifestyle.

Why is HEM controversial and what are the issues surrounding its use?

In 2018, HEM became a controversial topic when ANZ was investigated by the Banking Royal Commission due to its reliance on the measure for the majority of its home loan approvals. Following the investigation, many lenders have limited their dependence on HEM benchmarks in assessing home loans.

But why is HEM controversial? It all boils down to its generic nature that could underestimate non-essential living expenses, which could potentially lead to more borrowers being able to get a loan that they might not really have the capacity to repay.

Meanwhile, there is also a concern about how HEM does not consider the significant variations in living costs — applying a uniform HEM may ultimately not reflect the true cost of living for borrowers residing in different regions.

Using the HEM benchmark could also overlook circumstances unique to some borrowers, such as family sizes, employment situations, health conditions, and lifestyle choices.

For lenders, striking a balance between standardization and flexibility in loan assessments is crucial to ensure that borrowers are accurately evaluated for their repayment capacity while protecting them from potential financial hardships.

Regulatory oversight and ongoing refinements to the HEM calculation could help address some of the concerns and make the benchmark more robust and transparent.

What expenses are required to be declared when applying for a home loan?

The investigation on HEM has led to lenders tightening their rules in terms of analysing the living expenses of home loan applicants.

As required by the National Consumer Credit Protection Act 2009, your lender will need to assess your living expenses to know more about your financial situation when applying for a home loan. Some of the common living expenses you will be required to provide an estimate of are the following:

  • Food and Groceries: This includes expenses related to purchasing food, groceries, and household essentials.

  • Housing Costs: Lenders will consider your rent or mortgage repayments, property taxes, and home insurance expenses.

  • Utilities: This category encompasses bills for electricity, gas, water, and other essential utilities.

  • Transportation: Expenses related to commuting, fuel, public transportation, vehicle maintenance, and insurance may be considered.

  • Clothing and Personal Care: This includes clothing purchases and expenses related to personal grooming and care products.

  • Healthcare: Medical expenses, health insurance premiums, and out-of-pocket healthcare costs may be considered.

  • Education: If applicable, expenses related to education, such as school fees or tuition, might be taken into account.

  • Childcare and Child Expenses: Lenders may consider expenses related to childcare, including daycare or after-school care costs.

  • Insurance: Besides home insurance, other insurance policies like life insurance and personal insurance could be factored in.

  • Debt Repayments: Lenders will consider any existing debts, such as credit card payments, personal loans, or car loans.

How can expenses affect your borrowing capacity?

Assessing your expenses is an essential aspect of responsible lending. Lenders have a legal and ethical obligation to ensure that borrowers are not overextended or put under financial stress.

Lenders carefully evaluate your expenses to ensure that you can comfortably afford the loan without facing financial strain. Your lender will be able to determine your borrowing capacity, which refers to the maximum amount you can expect for your loan.

By examining your expenses, the lender can determine how much of your income is available to cover loan repayments after accounting for your ongoing living costs.

Online tools like Your Mortgage’s Borrowing Power Calculator can help you get a glimpse of how lenders use your expenses to calculate your capacity.