Have you ever felt that buying a home is too difficult and overwhelming? Home prices are too expensive and getting a mortgage has become much more complicated in recent years. This makes me think that it is a perfect time to talk about how to prepare to buy your first home.
Now, I’m not going to sugarcoat it. Buying a home is a complex process, and I intend to give you the full picture here. So today’s post will be a long one with some maths involved.
#1 - Purpose
First, you should start with a clear idea of what you want to achieve. Sounds cheesy, but this is probably your most important financial decision ever, so you better be really clear about what you are trying to do.
Think about the type of property you would like to buy. Should you try to buy the most expensive home you can, or aim for something more budget friendly and keep some cash? Should you buy an apartment conveniently near the city, or a house with big backyard much further away? Doing this will give you an idea of your price range, which will allow you to plan your finances accordingly.
Timing is another consideration. Generally speaking, sooner is better, but if another 6 months will give you higher income and more deposit, waiting may be the better decision.
You may also need to decide between buying an owner-occupied and an investment property, which may not be as obvious as you think. This is an interesting topic which I discussed in an earlier post. The general idea is that if buying an investment property can put you in a better position financially, it may be the better first purchase.
#2 - Deposit
After you have made up your mind about what you want to buy, it’s time to go into some specific numbers, hope you are paying attention.
There is a misconception that you only need 5 to 10% deposit for any property, this completely leaves out Stamp Duty and LMI which can be quite hefty. Stamp Duty is 4% of the price in most cases, and LMI ranges from 2% to 4%.
While minimum deposit requirement changes from minimum cash you need is 13% for your own home and 16% for investment properties. The only exception is First Home Buyers, who may indeed just need 5% in specific cases.
That said, the more deposit you have, the better. The 2-4% LMI that I just mentioned can be avoided completely if you have 24% cash (20% deposit + 4% Stamp Duty). Furthermore, your interest rate will also be reduced if you pay more cash and borrow less against the house.
Besides the amount, how you have been saving is also important. Most banks want to see a history of consistent savings, 3 months is the sweet spot, especially when you have lower deposit. What if you got a gift from family, or just sold another asset and got a big lump sum, clearly these will not qualify as savings? You can substitute savings history with rental history, or prove that you have owned the asset for some time.
Finally, let’s touch on Family Equity for a bit. This is quite complex so I will discuss in much more details in a different post. The general idea is that you can use the home of a family member, typically your parents or siblings, as additional security for the bank. This enables the banks to lend up to 100% of the home you are buying, some even lend you the Stamp Duty as well if necessary. Sounds really good, but there are additional risks associated with this type of loan, both for you and the banks. Therefore, this is generally offered to First Home Buyers, and has some strict requirements attached.
#3 - Income
Since how much you can borrow is a function of how much you earn, income is one of the most important factors determining your purchasing power.
Obviously, the more income you have, the better, but the banks also look at the type of income and how stable it is. Generally speaking, your salary will be fully accepted by most banks, though there are cases when it is not. If you have been in your job for less than 3 months, if it is a Casual or Contracting job, or your salary is mostly Overtime or Penalty pay, the banks may use a reduced amount to account for that level of uncertainty.
The other major source of income is profit from your own business, if you have one. Running your own business is a lot riskier than working a 9 to 5 job, so there are a lot more checks for this type of income. The business would need to have operated for at least 18 months to 2 years. Consistency in earning is also important, as wild swings between the years will raise questions about profitability of the business.
Income is one of the most important factors determining your purchasing power.
Rental income is another common type if you own an investment property. Keep in mind that no property can be rented for 100% of the time, as you tenants move in and out and repairs need to be done, so the banks will, again use a reduced amount. On the flip side, if you are buying an investment property, you can add its “prospective” rent to your total income, even though you haven’t owned it yet.
There is a misconception that I saw fairly regularly. Many seem to think that you could borrow against your asset without any income at all. This may be true for certain types of loans in other countries, but not in Australia, and definitely not for residential mortgages. You can have $10 million in asset but if Tax Return shows no income, you cannot borrow anything at all.
What about other types of income, such as dividends or income from Superannuation? These are acceptable but would only apply to a small number of borrowers, as not too many people have sufficient incomes from these sources to make a difference. This means most banks would treat these case-by-case so drop me a message if you want me to go into more details on these.
#4 - Liabilities and Expenses
After income, the next consideration is expenses and debts. These directly reduces how much income you have to service the loan, so the banks will look at how well you manage them.
My best advice is to minimise your debt. Anything from Car Loan to Student loan, Credit Card to a Zip Pay account, if you pay off and close all of them, you will be able to borrow the maximum amount your income can support.
That said, I understand it is not possible to clear off all of your debts at once. Prioritising is the next best thing. Anything with a high repayment will have the biggest impact and should be the first to be closed. Below is a list of common debts and how I would prioritise them:
Tax Debts are the worst kind and can mean automatic decline from the banks. Getting a loan to clear these debts are also very difficult if not impossible. You should aim to clear these off as soon as possible.
Credit Card and any Buy-Now-Pay-Later accounts are usually the first I would look at cutting, especially if you have a large unused limit. A Credit Card of $5,000 limit will reduce your home loan by $25,000 to $30,000. I would reduce my limits to the minimum, or even better, pay off and close these accounts if possible.
This one may surprise you, but student loans such as HECS or STSL can have a big impact. Student loan payment is based on your income, not on your remaining loan balance. If you are on a good income, it is not rare to pay off $50,000 in HECS and gain $100,000 in borrowing capacity.
Other debts such as car loans and personal loans may or may not be easy to close. Since these tend to have higher interest rates than mortgage, closing them is a good idea in most cases.
Minimise your debt
Besides debts, you should also pay attention to your monthly living expenses.
This is another one that may sound strange, you should keep your expenses down but only to a certain point. The banks will compare your expenses to a benchmark and if you are already spending below that, they will use the benchmark. This means going extremely frugal does not help with the loan, though more savings is always good so definitely do it if you feel comfortable.
What is more important is how you manage your spending. Do you keep up with all of your bills? Do you let your accounts go into the negative, or have a lot of dishonour fees? Do you gamble or buy lottery a lot? The banks look at all of these and many more to determine whether you would be a responsible borrower who pays on time.
#5 - Other Considerations
Above are the main points you should focus on to maximise your borrowing capacity. Besides those, there are a few other considerations that are good to know.
Be careful with making enquiries on loans. If you have made a lot of enquiries, such as credit card or car loan, they may drag down your credit score so much that many banks would not consider your application at all.
They also look at whether you have been in default or bankruptcy in the past. While these sound scary, the banks are actually quite reasonable in this regard. As long as you have a good reason, and have cleared the default or bankruptcy, many banks could actually consider your loan.
Another point that tends to catch people by surprise is your long-term outlook. If you are near retirement age, the banks will be more careful when assessing your ability to clear the loan. If you change your jobs frequently, or have long career breaks, they will be more reluctant in taking your income in full.
These are just a few examples of what they could ask. Since everyone is different, it is impossible to list out all the questions the banks can have. This leads to my next and final step.
#6 - Seek professional advice, either from a Broker or a bank
As you may have seen, getting a mortgage is a complex and often time-consuming process. Standard criteria are not always easy to understand and can change depending on your situation. Furthermore, the banks look at more than just numbers to determine your eligibility.
Speaking to a professional is the only way to know for sure if you qualify for the loan you need. They have intimate knowledge of bank policies and can advise how the banks will consider your particular circumstances. At my practice, we even plan ahead what steps you need to take if you are not yet ready, all to make sure that you put yourself in the best position possible when the time comes to buy your first home.
And that’s it. If you have gone through all of that and understand them all, congratulations! You now have the knowledge necessary to make possibly the most important financial decision of your life.
Still, there are a lot of little details and nuances that are important but cannot fit in this already extensive article. I strongly encourage you to go through my other posts, which will go deeper into each of the above steps.
If you have any questions that you wish I had covered, do leave them in the comment section and I will do my best to answer them.
Thank you for reading, and until next time, stay sensible.
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