Borrowing capacity and affordability are related concepts, but they represent different aspects of the home-buying process and have distinct implications. Taking on a home mortgage as a borrower in Australia entails significant responsibility. It is crucial to assess your ability to repay the loan and determine the affordability of the monthly repayments.
What is Borrowing Capacity?
Borrowing capacity is the maximum amount you can borrow without jeopardizing your financial stability. It is determined by various factors such as income, expenses, credit history, and other financial commitments. Determining your borrowing capacity involves several factors and is influenced by the bank’s assessment rate and risk appetite. Each lender has its assessment rate, leading to significant variations in borrowing capacity among different lenders.
In addition to the assessment rate, the bank considers various other factors. They incorporate a buffer when assessing your existing loans, accounting for any financial commitments you already have. Your income, including wages and rental income, and the limits on your credit cards are considered. The lender also considers the number of financial dependents in your household and applies a cost of living factor. This factor represents the amount the bank uses to estimate your living expenses, which may or may not align with your household expenses.
What is Affordability?
Affordability pertains to the amount you can comfortably repay each month without straining your finances. It considers your income, debts, living expenses, and other financial obligations. Assessing affordability ensures you can meet repayment obligations while maintaining a reasonable living standard.
Your affordability is closely tied to your lifestyle and the individual choices you make regarding your daily expenses and financial decisions. Unlike borrowing capacity, primarily determined by the bank’s assessment rate and factors such as income, existing debts, and credit limits, affordability reflects your spending habits and financial choices.
Everyone’s lifestyle and spending patterns are unique and can significantly differ from the cost of living estimate used by the bank to assess borrowing capacity. The bank’s estimation may not accurately align with your spending pattern.
Factors Affecting Borrowing Capacity and Affordability
Several factors can impact both your borrowing capacity and affordability. The key factors that influence both capacity and affordability are as follows:
Income
Your income plays a significant role in determining both borrowing capacity and affordability. A higher income generally allows you to borrow more and comfortably handle the repayment obligations. Lenders assess your income to evaluate your ability to repay the loan and determine the loan amount you qualify for.
Debts
The amount of existing debt you have affects both your borrowing capacity and affordability. Lenders consider your debt-to-income ratio, which compares your monthly debt payments to your income. Higher debt levels can limit your borrowing capacity and reduce affordability as it increases your financial obligations.
Credit Score
Your credit score is an essential factor for lenders when assessing your creditworthiness. A higher credit score indicates responsible borrowing behaviour, making qualifying for a loan easier and obtaining favourable terms. Conversely, a lower credit score can limit your borrowing capacity and increase the cost of borrowing.
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