Borrowing capacity has reduced by around 30% over the past year due to the impact of higher interest rates and the increased 3% interest rate buffer that banks must use to calculate your borrowing capacity. This was eloquently depicted in this chart by CBA in February 2023.
I wanted to explore the common strategies that people can use to safely maximise their borrowing capacity.
How to borrow safely
I’ve written several times that building wealth is a marathon not a sprint. Whilst it is good to avoid procrastinating and invest as much as possible, you should never take high risks.
When borrowing, it’s wise to plan for the worst but hope for the best. Look closely at your spending habits to ascertain how much you need to maintain a standard of living. Don’t rely (completely) on variable income such as bonuses. Test your ability to repay at higher interest rates – even if you think they are unlikely. And ensure you have adequate buffers in place to help you navigate any unforeseen changes in circumstances.
As a rule of thumb, if you are borrowing more than 6 to 8 times your total gross annual income, be careful. It could be a sign that you are borrowing too much. Consider the risks. You must have an exit strategy that you can implement if everything goes pear-shaped.
In my experience, it is unnecessary to borrow a huge amount to achieve your goals. People that do accumulate a lot of debt (i.e., what I would consider to be too much) usually do it because they are investing in the wrong properties. Property investing is a game of quality, not quantity. I would rather own one awesome, investment-grade property and have $1.5m of debt than a portfolio of 10 properties with $5.6 million of debt (I’m using an actual example of a portfolio that I saw recently). The former scenario will generate a lot higher risk-adjusted return over the next 20 to 30 years.
My overarching point is, be careful. Don’t overborrow.
Having said that, it is helpful to know what steps you can take to preserve and maximise your borrowing capacity. Here’s a few tips.
Consider using a charge card instead of a credit card
After many years (decades) of actively investing and using different banks, my wife and I ended up accumulating 7 credit cards! Notwithstanding that, they all charge an annual fee which is a waste of money, the aggregate credit limit was 6 figures!
Credit card limits reduce your borrowing capacity because the bank includes approximately 4% of the credit card limit as a monthly expense (to provide for a monthly repayment should you fully utilise the card/s). So, $100,000 of total credit card limits would result in a monthly expense of $4,000 in a banks serviceability calculation, thereby reducing your ability to borrow.
My wife and I always repaid our credit cards in full. We didn’t use them as a source of credit – merely to earn points. Therefore, a few years ago we cancelled all but one card (which we use for business expenses only) and obtained a charge card from American Express which we use for purchases, wherever possible. The advantage is that charge cards don’t have a credit limit because you must repay the full balance each month. So, they don’t impact your borrowing capacity.
Therefore, consider cancelling your credit cards to maximise your borrowing capacity.
If you earn variable income, be careful changing jobs
Many employees have a variable component as part of their overall remuneration package e.g., income that is contingent upon personal and/or company performance such as bonuses, STI, etc.
Most banks will include some of this income in their borrowing capacity calculations. They will usually average out the past 2 years of bonus income and include 80% of that amount in their calculation. Therefore, for this income to be included, they will want 2 years of history.
If you change employers but remain in the same/similar occupational role, a bank may only want one year of history if you can provide the history from your previous employer.
Therefore, if you plan to change employers in the future, consider how it will impact your borrowing capacity. Maybe it’s better to get your borrowing requirements in place before you make the job changes.
If you are self-employed, make sure you receive holistic advice
There is a myriad of things that an accountant might do that could unknowingly reduce your borrowing capacity. Some examples that we have come across with our clients include:
- Providing the lender with detailed information about depreciation claimed so that they can add it back to profit, as it’s a non-cash expense;
- Structuring distributions as a salary rather than unfranked dividends so that the income is included in serviceability;
- Not distributing to family members outside of the immediate family, such as parents; and
- Prepaying tax via BAS so that a company has enough franking credits to pay out a fully franked dividend.
Some of these matters can be quite technical and most people won’t appreciate the nuances. That’s why it’s important that your team (accountant and mortgage broker) collaborate with each-other, as they will have enough combined knowledge to find an optimal solution for you.
Selecting the right lender is also important. It can be very frustrating dealing with a lender that doesn’t adequately accommodate self-employed applicants – it’s like trying to fit a square peg into a round hole.
Rein in spending
You will need to declare what you spend in your loan application. The bank will probably also review your bank statements to verify your figures. Therefore, if your borrowing capacity is tight, it would be wise to pare back spending as much as you are comfortable to do. This will serve two purposes.
Firstly, it will ensure your bank statements confirm your spending habits.
Secondly, and perhaps most importantly, it will demonstrate to you how much you can contribute towards loan repayments if you must and what sacrifices you must make to achieve that. This will allow you to consider whether you are willing to make those sacrifices before you take out the loan.
Reset loan terms on all loans
If you have existing loans, you might consider recontracting the loan to reset the term back to 30 years.
For example, if you took out a principal and interest loan 5 years ago for $700,000 but have repaid the balance down to $500,000 (i.e., because you have made additional repayments), the dollar value of the principal and interest will be unaffected. If the interest rate is 5% p.a., your monthly repayment would be about $3,750. That’s because the contracted repayments are based on the original loan amount and settlement date, not the loan balance.
However, if you recontracted that loan and reset the loan term to 30 years, your minimum monthly repayments would reduce from $3,750 to $2,680. This reduces your minimum repayment commitment and therefore increases your borrowing capacity.
Of course, you can continue to make extra repayments to reduce this debt as fast as possible.
Therefore, if you have made a lot of extra repayments on a loan, consider resetting its loan term to extend your borrowing capacity.
Shorter or no interest-only term
An interest only loan is a 30-year loan. It is just the repayments for the first 5 years are structured as interest-only and the remaining 25-years are principal and interest. This means that banks include principal and interest repayments over 25 years in their borrowing capacity, not the actual interest only repayment. The shorter the loan term (25 not 30 years), the higher the repayment amount and therefore the lower your borrowing capacity will be. Reducing a loan term by 5 years increases minimum repayments by around 9%.
Therefore, if you set up all your loans with principal and interest repayments over 30 years, it will maximise your borrowing capacity. Of course, doing that might not be the best use of your cash flow, particularly if you have non-tax-deductible debt (a home loan).
I listed some other tips in this blog last year – see here.
A good mortgage broker will do this work for you
Everyone’s situation is different and there might be things you can do to safely maximise your borrowing capacity that are not discussed above. Therefore, it is important that you have an experienced mortgage broker on your side.
If you need help, you are most welcome to reach out to our most senior mortgage broker, Jodi McKeown – click here to do that.