Home loan lenders want the biggest slice of your wallet

In the nineteen eigthies a local bank manager working out what I could afford to borrow divvied up my pay packet this way: “A third for the taxman, a third for me … and a third for you.”

The rule-of-thumb that you can afford to devote about 30 per cent of your gross or pre-tax income to home loan repayments has been around for a long time and is still used by groups such as the Housing Industry Association as an indicator of likely mortgage stress.

However, these days lenders are just as likely to offer a sum that equates to 40 per cent of your gross income, and some go closer to the 50 per cent mark – in theory, leaving 20 per cent for you after the taxman gets his cut.

That sort of lending practice last week became the subject of an inquiry by Federal Parliament, amid growing concern about loan foreclosures and home repossessions. It also comes after the Australian Prudential Regulation Authority found that one in four borrowers is now being given a loan above the 30 per cent threshold, forcing some people below the poverty line.

Over the past decade there’s been an explosion of “innovative” products such as low-doc or no-doc mortgages and no-deposit home loans for people with poor or irregular credit histories, including pensioners.

At the same time banks have outsourced lending, with about a third of loans sold by commissioned brokers who benefit more from bigger loan sizes.

Easy money and questionable lending practices are not confined to Australia. The inquiry comes amid a meltdown of sub-prime mortgages in the US, with the Federal Reserve chairman, Ben Bernanke, warning “it might get worse before they get better”.

Rising interest rates in the US have forced up mortgage defaults and brought condemnation from politicians for the central bank’s failure to monitor the situation more closely.

A survey of lenders’ online mortgage calculators by Money found that a hypothetical couple bringing in a combined income of $81,000 before tax (one of them working part-time) could borrow anywhere from $300,000 to $400,000, depending on which lender they approached (see table).

At the top end, repayments amount to more than $3100 a month.

But just because your bank says you can borrow $400,000 doesn’t mean you should. Your loan application may be approved, but that doesn’t necessarily mean it’s affordable.

Jan Pentland, the secretary of the Australian Financial Counselling and Credit Reform Association, welcomes the House of Representatives Economics Committee inquiry.

“It’s something that’s been needed for a long time and [financial counsellors] have been disappointed in the lack of response from Government for quite a period now,” Pentland says.

A report prepared by the NSW Consumer Credit Legal Centre and released by the Australian Securities and Investments Commission in March 2003 highlighted issues in the sector, she says, but became “bogged down” in the federal-state legislative process.

Pentland says she has witnessed a big change in the way banks handle home loan applications.

Gone are the days when your local bank manager knew your personal circumstances and acted as a bulwark against taking on too much debt. Today three different people – if not three different financial institutions – might handle your savings, your credit cards and your mortgage.

The lender who puts the tick on your loan approval won’t be the collections officer who has to clean up the mess at the end of the day, Pentland says.

Risk is increasingly being transferred from lenders to borrowers.

“I guess the lender is looking at the value of the property and thinking, ‘as long as the value of that property is 20 per cent above the value of the loan, we know we’re going to be good,’ ” Pentland says. “It’s the family that’s taking the risk.

“If enough people pay back what they borrow, then I guess [lenders] are prepared to take the risk on the number of people who don’t.”

The trend to push more money at people is being driven by commission-based lending, she says. “It’s almost certain to be the case that whoever’s selling you that loan is either being paid on commission or having bonuses paid based on the amount of credit they sell.”

David Wakeley, the head of Virgin Money, says he is concerned that some lenders are overinflating a customer’s ability to pay.

“We recently gave a pre-approval to someone for $300,000 – they were looking for a property to buy and they wanted to know how much they could borrow, and that was the amount we felt we could lend them.,” he says.

“They called back a couple of days later and said another bank had given them pre-approval for $400,000.

“Those are massively different figures and you’d have to question whether the institution offering $400,000 was doing it to maximise their own profits and whether they were really acting in the best interests of their customer.”

Greg Tanzer, ASIC’s executive director of consumer protection, says responsible lenders take your ability to repay seriously. “But the consumer also has a responsibility to work out what it is they can afford,” he says.

“It’s all right for us to talk about the need for institutions to lend responsibly but it’s important also that people make up their own minds.

“There are cases where people have borrowed money and, even if they were advised that they could [afford it], if they had looked at it themselves they might have reconsidered.”

Tanzer says it doesn’t make business sense for a lender to hand out money with the expectation that the debt will go bad “but, all the same, there are competitive pressures out there”.

If you are turned down for a standard home loan, or you don’t have a deposit and want to borrow the full value, the temptation might be to try for a low-doc loan, where you don’t have to provide documentary proof of your income, or to go to a lender with less stringent criteria.

However, Wakeley warns that this is probably the point at which you should pause and reconsider.

“High [loan-to-value ratios] probably have a position in the market but it’s a very narrow niche, for unique financial circumstances. Our concern is that they’re being offered a lot more broadly than that,” he says.

Tanzer says of low-doc loans: “The onus is on you to accurately state [your income]. You should certainly never ever give in to temptation if someone is advising you ‘just bump your income up a bit’, because it’s a fool’s paradise.

“You might get the extra money but you will end up with a loan that’s unaffordable. And that just causes you much more stress and trouble in the long run than actually answering thoroughly and accurately, and living with the result that comes out at the end.”

So how much is too much?

There are a couple of rules of thumb that you can apply – such as the 30 per cent rule, or borrowing 3.5 times your gross annual salary – but the trouble with these rough guides is that they don’t take into account individual circumstances.

This means these rules-of-thumb should only ever be a starting point or a way to compare and weigh the sum your lender is offering.

The best way to work out how much you can afford to borrow is to work backwards – consider how much you can afford in monthly or fortnight repayments, based on a realistic budget. ASIC provides a budget planner at http://www.fido.gov.au – go to “loans and credit”, then “buying a home”.

Wakeley says he doesn’t like the rule-of-thumb that you can afford to apply 30 per cent of your gross income to repayments – let alone 40 per cent.

“We don’t go on gross income – we think that’s too coarse a measure,” he says.

“We like to look at after-tax income less living expenses. Some people’s lifestyle expenses are a lot higher than others so we’re quite wary of that rule-of-thumb.

“The real issue is that people’s circumstances do change quite rapidly. A lot of people are buying a house about the time that they’re starting a family, for instance, and that can have a huge impact on your finances.”

Wakeley says there should be a buffer of at least 25 per cent between the repayments on your loan and the upper limit of what you could afford. That gives you room to move if rates go up, or your income falls.

In the meantime, you can use the buffer amount to make extra repayments, increasing the equity in your home so you’re ahead should you hit a financial speed bump.

If the journey is smooth, you’ll pay off your mortgage early and save tens of thousands in interest charges.

The old adage that the best loan is no loan remains as true today as it has in the past, despite the easy money.

Stress test your mortgage
There are a few ways to stress test your approved home loan, to see that it really is affordable. Try these methods:

Higher interest rate Work out what your repayments would be if interest rates rose 2 percentage points. For instance, if your lender is offering a mortgage rate of 7.5 per cent, ask what the repayments would be if interest rates rose to 9.5 per cent. This test is worth doing even if you’re taking a fixed rate – interest rates may be higher when your fixed-rate term expires.

Lower income/higher expenses Redo your household budget and this time trim $300 off your estimated disposable monthly income – that is, what you have left over for repayments after all other expenses. Let’s say your household has $3900 left each month after living expenses (excluding accommodation). If that fell to $3600 because of an unexpected expense, less shift work, or because the costs of owning a home were greater than you thought, could you still afford your repayments?

The 25 per cent buffer Virgin Money suggests you should have a 25 per cent buffer between your repayments and your disposable monthly income.

Let’s say your loan offer amounts to repayments of $2750 a month. Add another 25 per cent on top, taking the figure to $3437 a month, and ask yourself whether you could afford that.

One strategy would be to apply that 25 per cent extra to your mortgage straight off so you’re ahead in your repayments should you hit a financial speed bump.

If you’re fortunate enough to have a smooth journey, you’ll pay off your mortgage early and save tens of thousands in interest charges.

How much can I borrow?
Money ran some numbers through the home loan calculators provided on lenders’ websites, using a hypothetical couple earning average weekly earnings.

We had one partner working full-time and the other three days a week, earning $56,860 and $24,120 respectively. That’s a gross monthly household income of $6748 (or $5487 after tax).

If prompted – and often we weren’t – we allowed for two children, $1500 a month in living expenses (not including rent), $3000 in credit card debt (with a $5000 limit) plus $1000 on a store card.

Of course, the websites clearly state the results from the calculator are indicative only.

Double would be trouble
When nurse manager Fran Common and her husband approached the bank for a home loan so they could upgrade from their unit to a house their bank offered them double the money they were seeking.

Common says they’d done their sums and felt they would be comfortable with repayments on a loan of about $200,000 but the bank offered them more than $400,000.

“At the time we went, ‘You’ve got to be joking,’ ” she says.

“How on earth are people meant to pay that sort of money back? We just took what we needed.”

The couple had experienced the high interest rates of the late 1980s and wanted to be sure they could meet repayments even if rates rose again. “We’d been bitten before,” she says. “We didn’t want to take something that we couldn’t comfortably repay.”

And they wanted a life as well as a mortgage. “We wanted to pay our bills, to be able to go overseas [to visit family in Scotland] and to be able to go out,” Common says.

Leaving a buffer also meant they could later afford to renovate the house they went on to buy.

In contrast, she knows of other nurses who work only nights – even though they’d prefer to be having dinner with their children – because they rely on shift allowances to cope with their mortgage.

HOW MUCH BANK CALCULATORS CAME UP WITH
Institution Loan amount ($) Monthly repay ($) % of gross income
Resi 307,000 2369 35.1
St George 310,000 2407 35.7
Aussie 347,000 2678 39.7
Westpac 348,174 2704 40.1
NAB 354,000 2760 40.9
Wizard 366,000 2842 42.1
CBA 373,078 2905 43.1
BankWest 382,000 2948 43.7
RAMS 390,000 3010 44.6
Mortgage Choice 394,000 3041 45.1
ANZ 402,707 3127 46.3
*RESULTS BASED ON A 25-YEAR LOAN, AT STANDARD VARIABLE RATE OF 8.07%

About: Rick Adlam: Rick Adlam has been helping clients with home loan finance since 1985 when he was home consultant with AV Jennings. Rick started Equity Home Loans in 1996 to help homeowners become property investors. Rick currently consults in the development of Mr Mortgage for mortgage brokers and HomeMate for new home buyers. Website: http://www.mrmortgage.com.au