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How banks determine your borrowing capacity

This article is part of a fictional case study series following "Sarah", a typical first home buyer in Victoria. Read each article to follow "Sarah" through a variety of articles exploring issues related to buying a home.

When Sarah was finally deciding to put an offer on homes, she needed to speak with a bank to get pre-approval. And when doing that, they determined how much she could borrow.

During a meeting with her lender, she felt a bit out of her depth. 

It's easy to feel that way. Buying a house requires dealing with a bank most of the time. But in all the talk about deposits and income, it still seems something of a mystery how these institutions actually figure out whether you have enough to service a mortgage.

So…how do they do it?

There are actually a few metrics banks and other financial institutions use. Let’s go through the main ones:

Your income

This is obviously the biggest one. After all, banks want to know if you can service your mortgage. Many have a requirement that your repayments be less than a certain percentage of your income.

But it isn’t just the size of your income – it’s also how dependable it is. For instance, did you just get your job and are on probation, or have you been in it for several years? Is it in a stable industry? Are you a contractor, or on a fixed, ongoing position? These are just a few metrics they consider.

Size of your deposit

A deposit isn’t just a tool to reduce your payments. It’s to show a bank that you have the ability to save up a sizeable amount of money over a certain amount of time.

How much debt you have

Paying off a house is more difficult when most of your money is going to paying down debts. Banks want to know if you’ve been spending your money on credit cards and personal loans when you could have been saving it instead. If you hold $50,000 in credit card debt, then it’s not a great sign that you will be able to handle a mortgage.

This is one of the reasons banks also conduct a credit check.

Your budget

You don’t need to be Warren Buffet to buy a house, but you do need to understand how much you’re spending on everything. This is why the more detailed your budget is, the better chance you have of convincing a bank you know what you’re doing.

Expenses

What are the ongoing costs you have in your life? If you have a number of financial liabilities - not necessarily debts - it may be more difficult to apply for a loan. Reducing those as much as possible to increase your disposable income will help.

These are just a few examples of what banks use to determine your credit worthiness. Don’t be overwhelmed, though. Just focus on saving, paying down debt, living below your means – and you’ll be fine!

SARAH'S TAKEAWAY:

Sarah thought she had all her ducks in a row before seeing the bank, but writing down a detailed budget will help her show exactly what she spends - and get her into a house sooner."

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