So you’ve saved up a deposit for your first house, you want to take advantage of the government’s first home owner grant while you still can, and the bank is actually prepared to lend you money. But how much should you borrow?
While Australia has not had the same problems with “sub-prime” borrowers finding themselves too deep in debt for a house which has collapsed in value (house prices can and do go down as well as up), there are certainly still people who have borrowed too much and are struggling to make their mortgage payments.
Once upon a time, many banks had rules of thumb for the maximum size for a home loan. A common rule was to lend no more than three times the borrower’s annual income (before tax). These days, even in the wake of the “global financial crisis”, it is not uncommon to hear of people being offered loans or four or five times their annual income.
Just because a bank is prepared to lend you enough to buy the house of your dreams doesn’t mean that the loan they are offering you isn’t too big! Borrowers have to decide for themselves how much is a safe amount to borrow and how much is too much.
One way to get a sense of a reasonable size for a mortgage is to consider extreme scenarios.
The term “mortgage stress” is used for borrowers whose mortgage payments have become so high that they are having trouble making ends meet. A figure commonly used to define mortgage stress is someone paying 35% or more of their income (before tax) on their mortgage.
At first glance, it may seem strange to use the one figure regardless of how much the home owner earns. But while people on high incomes pay a bigger percentage of their income away in tax, they also tend to spend more on luxuries and less on essentials and so they can afford to pay more of their after-tax earnings into their mortgage.
So, tax and spending patterns balance out and 35% gives a pretty good indication of mortgage stress for most borrowers.
Now, how big would a loan have to be to leave you paying away 35% of your salary? At the moment, home loan rates are around 6.5% to 7%, depending on the lender. When you first start making payments on your mortgage, most of what you are paying is interest (over time you end up paying back more of the loan and the interest component gradually reduces), so a good estimate is 35% divided by 7%, which is 500%.
So, if you were to borrow five times your annual salary, with an interest rate of 7%, you’d be in mortgage stress on day one and that’s not allowing for any increases in your mortgage interest rate in the future! Five times your salary looks like way too much.
The next thing to take into account is that interest rates can go up. Most mortgages in Australia are variable rate mortgages. More precisely they are known as “discretionary variable rate” mortgages, since your lender can change the rate to anything they like.
In practice, mortgage rates move more or less in line with the Reserve Bank’s “target cash rate”, although recently most banks have been raising their lending rates by more than the Reserve Bank target rate.
Over the last twenty years, the Reserve Bank’s rate has moved in a wide range, from 17.5% in the early 1990s to 3% last year. So it is certainly possible for mortgage rates to go up.
In fact, financial market professionals were stunned at the beginning of February 2010 when the Reserve Bank of Australia did not raise rates and with January 2010’s strong growth in job numbers, they are even more convinced that rates will go up in March.
When rates do start going up, they can move quite quickly. From August 1993 when rates started to move, they ended up 2.75% higher in less than 18 months.
What If Mortgage Rates Go Up 3%?
With this in mind, what if we allowed for mortgages to go up, say, 3%? Of course this doesn’t mean they couldn’t go further, after all rates are still at record lows, but it’s a good starting point. With rates at 10%, a mortgage of 3.5 times your income would have you in mortgage stress. That old bank rule of thumb of three times your annual income is starting to make a bit of sense!
Since everyone’s circumstances are different, the “no more than three times your annual income” test will not make sense for everyone. If you are already paying rent without any difficulty, then you should be able to handle mortgage payments of the same amount (another old banking rule of thumb).
Although keep in mind that once you own the house you are responsible for repairs and maintenance, which can throw up unexpected expenses. Also, if you are paying your rent, but not managing to save much on top of that, it’s probably not a good idea to take on a mortgage with payments higher than your rent.
Making Budget of Income & Expenses
To really come up with the best indication of how much you can afford to borrow, there really is no substitute for rolling up your sleeves and working out a budget of how much you earn and how much you spend. Working through your credit card statements and regular bills (phone, gas, electricity, insurance, car, school fees, childcare expenses etc) is the best place to start and then you can split your spending into essentials and things that you could cut back on once you have a mortgage.
Also, don’t forget that there are additional expenses when buying a house, including stamp duty (many people forget how big this can be) and legal fees. Once you have your budget and you know how much of a deposit you have saved up, use an online mortgage calculator to work out how big a loan you can afford.
There are a few other things that are worth keeping in mind when making the decision to take on a mortgage:
Fixed Rate Loans
If you are worried about your interest payments going up, it may be worth taking on a fixed rate for, say, three or five years. Very often fixed rates are higher than the variable rates, and if you do fix the variable rate may not end up going higher.
You should think of Fixed Rate Loans as a form of insurance not a bet on whether or not the Reserve Bank will be hiking rates.
For some people who fix their mortgages it can make all the difference in avoiding mortgage stress. Keep in mind that your interest rate will revert to a variable rate at the end of the fixed term and by then rates may have moved a long way.
Most variable rate mortgages allow you to pay down your debt faster than the minimum payments would require and then “redraw” those extra payments in the future if you need them.
Since interest on your own home is not tax deductible, reducing your debt as fast as possible makes a lot of sense and it also means that if interest rates do go up, your payments won’t go up as much and you have a buffer of savings to draw on if necessary.
Since fixed rate mortgages don’t usually allow for redraw, if you are thinking of fixing your interest rate, one option is to fix, say, half or two-thirds of your mortgage and the rest can be a redraw mortgage.
If you find yourself seriously ill or injured and unable to work, the last thing you want to worry about is keeping up the payments on your mortgage. An insurance policy can make a big difference in this situation.
Likewise, if you are paying off your mortgage jointly with your partner or spouse, and one or other of you is killed, losing your house as well would be a cruel blow.
A life insurance policy with a payout big enough to pay off most or all of the mortgage can prevent this from happening.
Most lenders will require mortgage insurance for loans that are more than 80% of the value of the property. Although the borrower pays for the mortgage insurance, it is only there to protect the lender so it’s really wasted money for you and it is good to avoid paying it. Of course, there’s a trade-off. If you are only going to borrow 80%, you’ll need to have a bigger deposit saved up or settle for a cheaper house.
There are a lot of things to think about when deciding to buy a house and sometimes the best decision is not to buy at all. But, if you are set on buying your own home, make sure you’ve done your sums and you don’t get yourself into trouble paying off your mortgage further down the track.
This guest article has been written by my friend Sean Carmody (@seancarmody and @stubbornmule on Twitter ). Sean is a Sydney-sider, blogger at Stubbornmule, father of 3, gadget-aficionado and music-lover who works in the financial markets.
If you’re a blogger or an expert about a topic I cover on this blog I encourage you to contact me and I’ll consider publishing your guest article here including generous attribution and back links back to your website as thanks for your contribution