Managing invested limited borrowing power has become ever more important to build an investment portfolio.
It's therefore important for investors to understand what can change your borrowing power, both positively & negatively.
This article unpacks how specific changes to your situation will impact your borrowing power. In a credit environment where borrowing capacities have been greatly reduced, it has become increasingly important for property investors to better manage their borrowing power when growing an investment portfolio.
The specific borrowing power impact will generally depend on a number of factors, including:
the type of income/expense it is;
which lender you look at, they treat different types of income/expenses differently;
how much you're borrowing;
the tax rate used;
the bank's assessment rate (the 'buffer') that they use to check whether you can service the new loan;
other factors (do you have an existing debt with the lender, interest rate changes, APRA changes, etc).
Given the array of factors, the most common answer given to questions about income/expense changes is that it depends. However, for ease of use, below are some quick ‘back of the envelope'' guidelines for investors to use.
- Salary/Business Income: Increase the average income earners salary by $10,000, will increase your borrowing power by ~$75,000.
The impact of this will fall for higher income earners, as they will pay a higher marginal tax rate. Given salary rises are potentially infinite, this is the most powerful way to increase your borrowing power long term.
Interestingly, bonus/commission/overtime income is treated similar to rental income (below) - with lenders treating this type of income as variable in nature and therefore only including 80% of it into their calculations.
- Rental Income: For the average income earner, a $10,000 increase in rental income will increase your borrowing power by ~$50,000.
Most lenders use 80% of rental income generally. Therefore additional rental income has a smaller impact than salary increases. Note there is also an implied cap with many lenders, plenty won’t take yields above 6% into consideration (CBA, NAB).
Note, when there is investment debt against rental income earned, some lenders will allow those interest payments to be ‘added’ back to offset the taxation consequences of this income (negative gearing). When included, the rental income impact moves closer to salary rises.
- Credit card limits: Increasing your limit by $10,000, will reduce your borrowing power by ~$35,000.
Credit card limits are generally assessed at 36% p.a. of the credit limit (regardless of whether you use it or not). This reduces your borrowing power by around $35-45k.
- Discretionary expenses (above bank minimums) - Increasing your expenses by $10,000 p.a. will decrease your borrowing power by ~$120,000.
Given your descritionary expenses comes out of net income, increasing expenses has more of an effect than gross salary increases.
One key part of the APRA changes that have been implemented has been an increase in minimum living expense figures banks had to use. This has been one of the main largest impacts on borrowing power reductions in recent years.
- Having another dependent reduces your borrowing by about ~$35,000.
Increasing the number of dependents adds at least $250 p/m to your monthly minimum expenses, depending on your current income level and the lender used.
Note, the impact of children usually has larger impacts with changes in income too.
- Going Interest only on a loan for 5 years instead of Principle and Interest repayments on a $500,000 loan will reduce your borrowing power by ~$35,000.
One of the changes APRA forced recently was having banks apply higher effective assessment rates for interest only debt (via shortened loan terms).
Now, most lenders will assess a 5 year interest only term over a 25 year loan period instead of 30. For a $500k loan, this increases the assessed repayment by a little over $200 p/m, having about a $33,000 impact on your borrowing power.
- Having ANY HELP debt on a median income will reduce your borrowing power by ~$60,000.
Those student loans can come back to bite young Australians hard!
HELP repayments are based on a sliding percentage depending on your income. On an $80,000 income, 5-6% of your income is withheld to repay this loan. That means an additional expense of $400 p/m. This reduces your borrowing by around $60,000.
Therefore for some at the edge of servicing that have a small HELP debt, it may make sense to repay this loan. Repayments are based on income, not loan balance/size.
- Obtaining a novated car lease for a $20,000 vehicle that includes all running expenses instead of a personal loan will reduce your servicing by ~$40,000-60,000.
Novated car leases usually include things like interest, fuel, car servicing, etc, into the monthly repayment amount, whereas personal loans usually have lower repayments because they only include the interest repayment. The other car costs can be included in the banks minimum living expenses for those that have personal loans. Therefore, Novated car leases do more damage as they potentially ‘double dip’ the living expenses.
Note the impact on borrowing power varies significantly depending on the specific arrangements of the lease. I’ve used an online calculator that breaks down the novated car lease costs for a $20,000 car – the additional running costs other than finance equate to around $400 p/m. This varies depending on finance terms, km’s driven (fuel cost impact), etc.
- Deciding to buy a $500,000 property (100% financed) to live in vs rent @ $500 p/w will reduce your borrowing power by approximately ~$180,000.
The expense factor included in lender calculators for a $500,000 owner occupier mortgage debt is around $3.4k p/m (despite potentially only paying $1.75k p/m in interest). If instead, that someone rented the same place at $500 per week ($2,166 p/m), lenders will take it exactly at $500 p/w in servicing assessment. No loadings are applied for actual rental expenses.
In this scenario, that’s a ~$1,250 difference in your monthly expenses! Therefore, under some lender calculators, you’ll be able to borrow $180,000+ more for investments by making the choice to rent instead of buy in this scenario.
The above aren't anything but quick guidelines, if you want more specific responses your best talking to your broker. The actual amounts will vary from the above depending on the range of factors mentioned at the start of this article.
Original article: http://www.apimagazine.com.au/property-investment/calculating-changes-to-your-borrowing-power