How much money can I borrow?

The question asked most often about mortgages or home loans, is "How much money can I borrow?". There are many answers to that question, but the reality is only one is correct.

There are two critical 'affordability' calculations that are similar with any lender. One is Loan to Valuation Ratio or LVR, the other is Debt Serviceability Ratio [or a range of other similar terms] or DSR.

Loan to Valuation Ratio

LVR is a measure of any debt as a percentage of total asset value. With home or property loans this can vary widely but would range from 50-60% up to around 95%. That depends on the type of property used as security [commercial, rural, land only, industrial, remote housing, standard residential] and the type of loan and borrower. Ranging from impaired credit through to an A1. The 'V' or valuation is based on the lender appointed valuers report. No other figure is relevant or generally considered, unless there has been an unintentional error or a flagrant mistake in the value or process. Most unlikely.

Debt Serviceability Ratio

DSR is a measure of the cost of servicing the debt as a percentage of income. This may also be represented a 'times cover', meaning a multiple of the cost that must be met by income. This can be much more elastic. It may depend on income sources, whether the lender uses gross or net income, how much may be added back in to income for self employed people. It will also depend on the 'reference rate' that is used in the calculation. This is generally the current variable interest rate plus another 1.5-2%. This builds in some room in the calculation for potential rate rises and tests the potential for the borrower to be unable to pay the loan repayments required. This serviceability calculation can vary widely between lenders and may also include allowances for the type of property used as security.

What DSR should illustrate is what loan amount is affordable or manageable. The challenge is that it usually relies on averages and approximation rather than accuracy.

What does an average family with two children spend on household expenditure; what should be allowed to run two cars; and so on. What also is generally forgotten about is the ability for the borrower to pay the loan back. to reduce debt. That is factored in, if even required, by making a part or all of the loan Principal & Interest which by it's nature means there is an element of principal reduction.

And The Only Correct Answer Is...

The only correct answer to the question "How much money can I borrow", is "As much as your real accurate cashflow will allow to a) support the loan, and b) reduce the loan". Everything else is academic. Avoiding this fundamental and most obvious answer is what leads people into loans they can't afford and having homes taken from under them. The recourse is swift and brutal. Lenders will throw money at seemingly 'good risks', but in so doing look no further than the high level numbers. That is not to say that people cannot nor will ever afford loans of a certain size, but if their cashflow doesn't accommodate, it may all end in tears.