Borrow smart, not because you can

Borrowing to buy property is normal, but the amount of debt you take on shouldn't always be what the bank throws at you.

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Imagine this: I’m a bank. I’d like to lend you more money than you need to buy your dream house, even if that puts you at the poverty line, just so long as you pay me interest every month for the next 30 years. Deal? Great… keep thinking of that house.

Borrowing capacity is the single biggest influencer of property prices in the current market. But just because you can borrow it, doesn’t necessarily mean that you should.

The simple fact is that in most cities and towns where there is not an oversupply of housing stock, prices are being driven by how much an individual or family can borrow.

For the majority of Australians, when we want to buy a house, we end up borrowing as much as the bank will lend us, otherwise we can’t afford to get into the market.

With interest rates at record lows, thanks to the official cash rate sitting at 1.75 per cent, Australia’s borrowing capacity has grown significantly over the last 10 years.

But it is pretty logical to think that if interest rates rise over the longer term, which they are predicted to do, then borrowing capacity should fall.

It can also be influenced by prudential lending standards, which are the rules placed on banks in respect to the amounts they are allowed to lend to borrowers.

So how can we translate changes in borrowing capacity into real numbers? The easiest way to do this is with an example.

Banks will typically lend you an amount equal to your ability to save, divided by the current interest rate, plus a 2 per cent buffer for any risks.

So if you have the required deposit, and a savings capacity of $50,000 a year, and the current interest rate is 4 per cent, the banks will therefore lend you $50,000 divided by 6 per cent, which is $833,000.

If interest rates increased by just 1 per cent, the amount the banks would lend you would fall to $714,000 – which is $50,000 divided by 7 per cent.

This 1 per cent difference in interest rates equals $119,000 or a 14 per cent difference in the amount that a bank is prepared to lend, and potentially a similar drop in property prices over the next few years.

When my clients ask me how much they can borrow to purchase property, I generally tell them to think long and hard about their own borrowing capacity when purchasing property, and to not be driven by how much a bank or mortgage broker says they will lend.

If you borrow as much as a bank will lend you, there is a risk of being exposed to tightening lending standards, which could make you a forced seller in a market downturn.

Get on top of your own borrowing capacity, don’t rely on someone else to set it for you.

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