Why Is My Borrowing Power So Low! 5 Best Reasons
Whether you’re buying your first home or your next investment property, you always wondered: why is my borrowing power so low? There are actually many factors in play when banks assess your borrowing power. In this blog, I’ll mainly focus on serviceability of your loan, as this is one of the major variables that banks scrutinise the most.
Have you ever used the bank’s affordability or borrowing capacity calculators, where they ask you to input some numbers such as income, expenses and debt? The calculator then magically spits out a number telling you that you can borrow $900,000 to buy your first home. You then think wow, that’s awesome, so you apply for a mortgage through that bank and the approval ends up coming back significantly lower than what you expected from the bank’s mortgage borrowing calculator. Why is that?
This is something that all banks use and it’s called the serviceability test rate. An analogy would be if you were travelling overseas for a holiday and you needed to exchange money. You’ve got a budget in mind but you build in an extra safety net, usually between 10-15%, in case you overspend or the prices end up being more expensive than you initially thought.
Banks are very conservative and cautious when it comes to lending money because the hardest part is not lending the money out, but ensuring that their money is being repaid.
Note: I use borrowing power & borrowing capacity interchangeably as they mean the same thing.
What is the serviceability test rate for mortgages in New Zealand?
Time for some history. Banks have always used a serviceability test rate, but ever since the global financial crisis back in 2008, they have become even more cautious due to what happened in America. The Americans leveraged too much without placing restrictions on borrowing, and when interest rates started to increase (which they did), a lot of those homeowners defaulted on their mortgage repayments.
That pattern ultimately trickled to New Zealand. In order to protect Kiwi’s should interest rates suddenly rise, the banks test their potential borrowers at a higher interest rate.
As of September 2020, the lowest interest rate at the big 4 banks is 2.49%. The current mortgage serviceability test rate is between 5.5%-7.0% and it’s tested over a standard 25-30 year loan term. Every bank is different and has their own serviceability test rate, which is why there is such a variance.
This is why when you plug in your numbers into the banks’ borrowing capacity calculators, it shows an amount higher than usual, as they are either using the floating rate or the current lowest interest rate.
When I first started helping clients buy their first homes or investment property, the average test rate was between 7.0%-7.9%!!
What causes the Serviceability test rate to increase or decrease?
The mortgage serviceability rate that banks use will usually change when the Reserve bank of New Zealand sets the OCR (Official Cash Rate). As of September 2020, the current OCR is 0.25%.
Now it is up to the banks’ discretion. When the OCR was reduced to 0.25%, it took about a couple months for the banks to make the change and reflect the lower rate. It’s the banks that lend the money and they are risk averse, so maintaining a higher test rate allows the banks to manage the risk accordingly and not to be too overexposed in the mortgage market.
Why do some banks have a lower serviceability test rate?
General rule: the larger the bank, the more capital they have and so the more money they have to lend out. Therefore, they can take on a bit more risk compared to their competitors. However, a lower serviceability rate doesn’t usually mean you can borrow more from that bank, as it may mean their other criterias will be higher such as their expense category.
Why is my borrowing power so low?
Now that we’ve covered the biggest reason why your borrowing power is so low, there are many other reasons why that could also be the case.
Below are 5 typical reasons why:
Credit card debt - Banks look at the limit of your credit card, not the balance or even when you pay off the balance each month. The bank takes 3% per month on your credit card limit.
Student loan debt - Even though it’s an interest free loan, you’ve got a financial commitment to repay this loan.
Living expenses - Banks internally use their own living expenses on each of their customers. They’ve got a calculator that changes for each household, for example if you’re single vs a family of 4. Even if you save 90% of your income, the bank will automatically apply their own living expenses. Typically banks use CPI (Consumer Price Index) which measures how much a basket of goods cost.
Existing mortgage - Such as your mortgage. You’ll now be tested at the serviceability test rate regardless of whether you’re paying the lower interest rate.
Short term debt - Taking out any short term debt such as personal loans or car loans will have a detrimental effect on your borrowing power! Basically it could mean not getting your approval because your repayments are too high.
Bonus - Deposit - Having less than 20% deposit will affect your borrowing power, because if you had 10% deposit there are other charges or fees that banks can impose on their customers. These being Low Equity Fees or Low Equity Margins. I’ve written an article on it here. They will also seek a higher minimum UMI requirement which is different from each bank.
Once all the information is collected, it’s then reviewed and inputted into a calculator which will come out with a number at the end of the month. Most banks use something called UMI (uncommitted monthly income). All that shows is whether you have surplus money each month after all your expenses have been accounted for. For example:
| Income | ($) Monthly |
Applicant Income 1 | $5,000 |
Applicant Income 2 | $3,000 |
Total monthly Income | $8,000 |
Expenses | |
Mortgage repayments | $4,150 |
Credit Card | $150 |
Short term debt | $0 |
Living expenses | $1,800 |
Total expenses | $6,100 |
Uncommitted Monthly Income | $1,900 |
Here is a case study that I’ve recently done by helping a family into their first home:
This is for a family of 4:
- $85,800/year - Dad is a foreman and earns $33/hr, contracted for 40 hrs a week but on average works 50 hours a week.
- $100,000/year - Mum is an accountant
- 11 year old son
- 3 year old daughter goes to daycare ($300/week)
- $120,000 deposit (combination of Kiwisaver and savings)
- $1,100,000 is their maximum purchase price
- $980,000 is what they need from the bank
- 89% LVR (If you’re uncertain what LVR is, here is a blog)
One bank had a test rate of 5.80% and another had a test rate of 6.09%. The lower test rate bank did not meet their requirements, because the UMI needed to meet the minimum. On the other hand, the bank with a higher test rate approved their loan because it met their UMI policy requirements.
Based on the case study above, it shows that even though one bank said no (and it was also the main bank they were with), another bank says YES. It’s always best to explore your options and also save time by using a mortgage adviser so they get to spend their time on the weekends with family.
Every bank’s policy is uniquely different, refer to the case study above. The bank that approved the loan at the higher test rate could potentially borrow more, their capacity was another $100,000+, that other bank would have said no.
How to improve my mortgage serviceability to the bank?
One of the easiest and quickest ways to improve your borrowing power is to reduce and remove your short term borrowing. This will increase your borrowing capacity a lot.
For example, for every $10,000 credit card limit you have, it can reduce your borrowing power by $45,000 - $50,000!!
Banks will allow you to have boarders at your property. This will improve your borrowing capacity. Most banks allow you a maximum of 2 boarders per house paying between $150-$200/week. Even though they may pay you $250/week, the bank will still only accept what’s within their policy. This is dependent on each bank and your financial situation, for example if you have 10% deposit, some banks won't allow any boarders or just the one boarder.
It all comes down to which bank suits your needs and requirements, as you’ve seen from the case study above. One bank said no and the other bank was happy to give them approval for their first home!
How has COVID-19 impacted lending and borrowing power?
Since Covid-19, there is no doubt that this has impacted the banks lending appetite. They’ve really tightened up their lending policy due to the uncertainty in the economy.
The two key areas that banks are tightening in on are:
- Self employment
- Specific industries, such as hospitality, retail and tourism
In saying that, if you work in an essential service such as the medical field or if you know your income is stable, then the borrowing capacity is now higher than ever and the affordability to do so due to low interest rates has driven house prices up like crazy!
Solutions to improve your borrowing power
The first step is to really look at your finances and see what type of debts you have and how much. Secondly, find out how much deposit you really have.
From there, you need to book in a time with a mortgage adviser/broker and sit down with them to work out the best solution for you. A great experienced mortgage broker will break down all the jargon and make sure the process is as smooth as possible for you. You can book a free no obligation call with me here.
With the property market being so hot right now, you want to make the most of this time before it’s too late and you end up missing out on the property.
If you currently own a home, some questions to ask yourself are:
- How does your current mortgage align with your future financial goals?
- How is the loan structure set up? Are you paying a significantly higher interest rate?
- Should you look at refinancing to increase your borrowing power?
- Is my current bank offering the products I need, such as offset accounts and revolving credit accounts?
Conclusion on borrowing power
Why is my borrowing power so low? Hopefully, you got some value from this blog and that I’ve answered your question on why your borrowing power is low. Banks are just very conservative in nature. They’ve got multiple stakeholders to worry about, their shareholders and their customers too because at the end of the day they are in business to make money.
To summarise on why your borrowing power is low:
- Banks use a high interest rate to test their customers between 5.5%-7.0%
- Your short term debt is holding back your borrowing capacity
- Your living expenses are high, such as daycare
- You have a low deposit
Ways to improve your borrowing power
- Get a higher paying job
- Reduce short term debt
- Increase the size of your deposit to ideally 20%
- Look at having boarders in place
The two biggest factors the banks look at when they review your application for a home loan are Deposit & Serviceability. Today we covered serviceability, but in fact I’ve also already covered deposits, being LVR (link here to read on it).
If you’ve got questions, feel free to make a comment below.
Because everyone’s financial positions are different, the above is not specific advice but rather just general advice. If you want a more tailored and personalised approach for your needs, you can contact me at will@simplyfinance.co.nz or book in a time with me below.