How do banks work out your borrowing power (Servicing position)?

House prices in major Australian cities are astronomically high and inevitably, most people need to borrow money from a bank in order to fund a housing purchase. It is difficult however, to ascertain how much money the bank will lend you and can feel like a bit of a black box.

In this post, I will try and explain how a bank works out how much to lend you and some of the limitations that banks themselves face when deciding how much to lend you.

How do banks work out your borrowing power/Servicing position?

Whilst the exact formula used by each bank is different, there are a few core principles that remain common for every lender when they are trying to decide how much they can lend you. The key behind it all is your capacity to repay the loan that you are taking out. In bank speak, this is your servicing position or serviceability.

The banks work out your servicing position by looking at a number of things; the most common of which are your income, expenses, liabilities, the banks credit policy and your credit history. They want to make sure you have enough money left over to pay back the loan, are not purchasing something which is of high risk to them and you display characteristics of a good borrower who is likely to meet his or her financial obligations. Let’s take a look at each of these attributes:

Income

The first thing the banks or any lender wants to know is how much money you earn and how stable that income is. While it’s generally easy to work out how much an individual with PAYG (pay as you go) income gets (this is someone with a job who received regular payslips), it can be tricky to calculate income for someone who has their own business, is self employed or receives different types of investment or even centrelink income.

For PAYG income, it’s pretty straightforward, the banks will look at your payslips to see how much you earn. However the banks will be looking for a couple of other things in your payslips. They will want to know if you have any salary deductions and the reason for those deductions, for example if you are paying off a loan through salary sacrifice, they will need to deduct those repayments from your overall income. They also want to see if your income is stable and to do this, they will see what your base income is and what amount of income you are getting from overtime work, commissions work, temporary payments etc. For any income that is less stable, the banks have their own policies on whether they will allow the use of that income and if they do, what mitigants they put in place (see credit policy below). As an example, most banks will allow the use of overtime income if you can show that you receive consistent overtime across a reasonable period of time and they will generally use 80% of that income.

For other income types, the banks have their own policies in place but will generally use a percentage of the income with the exception of self employed income. A few examples of this – most major banks will use 80% of rental income (with exceptions of property type), they may use 80% of dividend or investment income etc.

For self employed borrowers, the banks generally look at how much money your income your tax returns show but they also understand that the businesses and self employed people are trying to minimise their taxable income and have expenses such as depreciation which sometimes isn’t really an expense at all. So they may allow you to add that bank in as income.

Liabilities

Once the bank knows how much you earn, they want to know how much you already spend so they can work out how much money you actually have left over. To do this – they have to look at two types of expenses; your existing loans and debts (these are liabilities) as well as your living and household expenses.

In terms of liabilities, you will generally need to provide any existing loans that you have including any types of home loans, personal loans, margin loans, lines of credit, overdrafts etc. The banks will usually ask you a few things such as how much the loan is for, how much interest you pay, how long you have left on the loan, how much your repayments are etc. For most debts, it’s your repayment that the bank is most interested in. To work out your borrowing power, they may also apply a ‘buffer’ on that repayment amount. This basically means that they increase that repayment amount slightly in their calculation to ensure that if interest rates went up, you could still afford the loan.

Other than loans, the banks also want to know about any revolving lines of credit that you have, the most common of which is a Credit card. For credit cards, the banks will look at what the limit on your credit card is and then use a percentage of that limit to make an assumption about your repayment. Usually this is around the 3.5%-4% mark. This is important to know because if you have a credit card with a $10,000 limit, even if you don’t owe any money on it, the bank will still assume a repayment of $350-$400 a month.

Expenses

Once your income and liabilities have been worked out, the banks want to know about the money you spend to live. They categorise these into two types of expenses; Fixed expenses and variable expenses.

Fixed expenses are things like your electricity, rent, water, internet etc. Basically things that will generally be a consistent payment. Variable expenses will be things like your groceries, entertainment, eating out, petrol/transport etc. These are areas where you spend money but the amount can vary and they’re using an average.

One of things the banks need to do is compare the expenses you declare to something called a Household expenditure measure (HEM) benchmark. I could write another blog on the HEM benchmark alone but this is basically a benchmark approved by banking regulators as a measure of how much an average person spends on living. The benchmark is based on research completed by the Melbourne Institute and looks at things like income, where the person lives, how many dependents they have etc and prescribes a dollar amount that should be used as a minimal expense. This is important to know because if your expenses are below the HEM benchmark, then the bank will use the HEM benchmark as your expenses instead of what you declared. The HEM benchmark is also updated every few months to ensure it is current. You can generally do a quick google search and find a few sites that give you an indication of what it will be for your circumstances.

The banks Credit policy

The banks generally set their risk appetite to ensure they are generally not taking any undue risk. The boundaries of their risk appetite are generally documented in their credit policy and incorporates a range of things in terms of what they will and will not accept due to the nature of that risk. The Credit policy can be quite comprehensive and includes their policy on income and expenses but a range of other things as well.

Whilst the policy varies between the banks, examples of things things banks want to look for are: the area in which you are purchasing, whether it’s a house or an apartment, whether your land is flood prone or has other risky attributes, purpose of your loan, area of your land, use of the property and so on. If you fall outside of these attributes, the bank may still consider your loan if they think you have sufficient risk mitigants in place and whether they are legally allowed to lend you that money as a residential loan instead of a business loan.

Your Credit history

Finally there is your Credit history, it doesn’t matter if you earn a lot of money and can show that you are able to easily afford the loan, the banks will look at your history on loans that you’ve taken out in the past, especially the last two years and check if you made your repayments on time. The banks can check your credit file through a few sources, the most common of which is Equifax (previously Veda). Equifax is a company that most lenders integrate with and send information to every time you make an application for a loan, you take out a loan and anytime you miss a repayment on a loan over the last 2 years.

So when you apply for a loan, the bank firstly tells Equifax that you have applied for a loan and then Equifax tells the bank how many other loans you have applied for and if any of the other lenders have reported missing payments from you. There are regulatory requirements for the banks to do this and this is also called your credit file or credit report.

Working out your borrowing capacity

Once the banks have your income, liabilities and expenses they will see how much money you have left over after paying for everything and ensuring it’s all within their policy. They will then use that leftover money to calculate how much they could lend you to repay with that left over money. They also use a higher interest rate than the actual interest rate when calculating this amount in case interest rates went up to ensure you can comfortably make those repayments. Once again, this a regulatory requirement for the banks as well.

So there you have it, the banks calculate your borrowing position based on a bunch of factors but ultimately it achieves two purposes. One is that it helps minimise their risk on giving out a bad loan and secondly it also ensures that they don’t lend you more than you can afford.