A quick google search gives you an idea just how much information exists for borrowers interested in the income and home loan relationship.
However, living expenses that can be just as fundamental in determining borrowing capacity for a home loan—but has just over 10% of the search results.
Coming up with living expenses for a home loan application might sound easy enough, but how can you put an accurate number on it?
When it comes to living expenses for a home loan, what exactly do lenders ask for? Living expenses as they are now, or what they can be?
What are living expenses for a home loan application?
Living expenses for a home loan refer to the regular costs expected to be incurred by an individual or household to maintain a reasonable standard of living. Living expenses for a home loan are usually expressed as a monthly amount, and are an important factor for lenders to consider when assessing a borrower’s ability to repay the loan. This includes expenses such as food, transportation, utilities, childcare, entertainment, and any other necessary expenses.
The reason for the borrower typically providing a declaration of living expenses for a home loan application is to ensure their income can cover both the monthly loan repayments, living expenses and any other regular commitments.
The lender puts an emphasis on a living expense declaration, so it needs to be more than just a guess. This is the reason I consider living expenses one of the three essential areas to understand before applying for a home loan.
How do living expenses impact borrowing capacity?
Overstating your expenses can reduce your borrowing capacity.
Understating your living expenses may leave you with a home loan you may not be able to afford.
Living expenses can directly impact borrowing capacity. When lenders assess borrowing capacity, they need to see that a borrower can repay a loan without being put in the unfortunate position of having to sell their home to do so.
If a borrower has high living expenses, it can reduce their capacity to make loan repayments, which in turn can decrease the amount of money a lender is willing to loan them. The opposite is also true.
Here is a borrowing capacity calculation illustration for a family of four in Australia with a combined annual houshold income of $200,000.
So, a $1,000 difference in monthly living expenses means almost $120,000 difference in borrowing capacity for this example. A $2,000 difference in living expenses changes borrowing capacity by almost $240,000.
Rather than gloss over the living expenses for a home loan application, it could be worth taking some time to understand what your living expenses are.
Interest rate and other buffers
Australian lenders ensure there are some buffers allowed for when looking at borrowing capacity.
One often talked about buffer is when lenders us a higher than actual interest rate for their home loan assessment. Lenders can also use “shading for less certain income types – like bonuses.
Lender buffers are part of the home loan assessment process within the lenders control.
Living expenses are something for the borrower to prepare and present to the lender so their home loan application can be assessed with accuracy.
Types of living expenses included in a home loan application
Types of living expenses included in a home loan application generally cover two main areas:
Basic living expenses and additional living expenses.
Some commitments like repayments for personal loans and credit cards are not include as part of living expenses.
Basic living expenses are considered essential to maintain a basic lifestyle for your given situation. These can be items like groceries, clothing, electricity, and transport.
Additional expenses do not always apply to everyone, such as private education, overseas travel, boat maintenance and beauty treatments.
When making a declaration of living expenses for a home loan, borrowers need to carefully consider if any expenses could be considered discretionary. The question a borrower should be asking themselves is:
Would I be willing to forgo or reduce this expense if it meant prioritising home loan repayments?
If the answer for any expense type is yes – then that expenses could be classed as a discretionary spend. Borrowers can consider adjusting discretionary expense figures when preparing their living expenses figure. It may be that a borrower continues to pay for discretionary expenses long after getting their home loan—and never need to adjust them in.
If discretionary expenses are removed or adjusted for a living expenses declaration in a home loan application, you are acknowledging that you could change your spending behaviour if it came to it—and still maintain a reasonable lifestyle.
As in many finance-related assessments, there needs to me some reasoning behind any adjustments.
Factors that can impact living expenses
Perhaps the question should be, what doesn’t impact living expenses?
Living expenses can be impacted from many life decisions – from big ones to seemingly small ones. The decision may not even have a financial feel, but below I outline nine factors that can have an impact on living expenses.
Inflation
Inflation is a key reason why you should keep any eye on your living expenses, especially if you have not done so for a while. Many factors I cover are ones you can have a choice over.
Inflation is one aspect of living expenses that you cannot do much about at all. It is a function of something much bigger than the decision between eating out or dining-in.
Inflation is the reason prices seem to always be going up – from coffee to houses. Not many items are speared from inflation.
Location
Living expenses can be impacted greatly depending on where you live. For example, cities tend to be more expensive than regional areas, and some cities are more expensive than others. The cost of housing, food, transportation, and other expenses can all be affected by location.
Income
Your income level is another major factor that can impact your living expenses. People with higher incomes may be able to afford more expensive housing, travel, and entertainment, while those with lower incomes may need to be more careful with their spending.
Family size
The number of people in a household can also impact your living expenses. Larger families may need to spend more on food, housing, and other expenses than smaller families. Children can have a significant impact on living expenses of a household. Their impact will depend on decisions around expenses such as childcare, leisure and education.
House running costs
The decision around buying a home will also affect monthly living expenses long after settlement. Bigger houses could cost more in utility bills—water, gas, electricity.
Extra features of a property could affect living expenses in different ways. A pool might add to electricity and water costs, whereas rooftop solar panels could bring electricity costs down.
The impact of buying a smaller dwelling could see lower living expenses like electricity, but could also impact living expenses with quarterly body corporate and strata fees.
Transport
Transport costs will depend on the quality and cost of transport networks in your area. If you are not on public transport then vehicle choice will have a direct impact on living expenses through insurance, maintenance, and fuel costs. A great example of this could be the running costs of an electric vehicle versus a petrol-fuelled vehicle.
Health care
Healthcare costs for households can vary widely. These can be particularly high for those who have chronic health conditions—even with private health insurance.
Child education
For those with children, the education component of living expenses can be a major cost. Private school fees, tutoring, and other education-related costs can add up quickly, particularly for big families.
Lifestyle choices
Your lifestyle choices can also impact your living expenses. For example, if you enjoy dining out, traveling, or other expensive hobbies, you may need to budget more for these activities than someone who enjoys more low-cost activities.
Benefits to understanding living expenses
In my experience as a mortgage broker I have seen clients who know their living expenses and those who don’t. Those who know their living expenses are the clear minority.
Those who don’t know their living expense generally fall into one of two categories:
Don’t want to know
or
Haven’t needed to know—until now.
Here are some great reasons for understanding your living expenses.
Home loan planning
Home loan applications need borrowers to estimate there living expenses. Given living expenses directly impact borrowing capacity this should not be a guess, but a well-informed estimate.
Formulas that tell you a percentage of income to allow for repayments completely ignore your living expenses.
Many people leave it to a finance professional to work it out for them, but if you know your living expenses then you should know how much money you have leftover each month—and so have an idea of the home loan repayments you can handle.
Over-spending
It can be better to recognise over-spending early rather than when it is too late. Many of us spend more than we think we spend and that can be okay. If it does not get in the way of your goals, then it can be a non-issue. However, if you have any finance-related goals, then understanding your living expenses can be a great starting point towards achieving them.
Goals that can be affected by over-spending are:
- Home loan application that relies on a living expenses declaration.
- Saving a deposit for a house.
- Saving for anything really – wedding, holidays, retirement.
Overspending more than you earn should be recognised as soon as possible—goals or not. Spending to this degree can lead to a reliance on the type of lending that can hurt your credit score – think pay-day lending and personal loans.
Make informed spending choices
Put a figure on your spending and decide if it is worth it: eating out, coffee, work lunches for example.
You know the maths. One coffee ($5) a day x five days a week x 48 weeks a year = $1,200 per year
And that is before any lunch calculations.
Subscription creep
You might be surprised how many under-utilised subscriptions are being paid for. Cutting unnecessary subscriptions can be a quick financial-win.
Money discussions
Money discussions, while often difficult, can be tricky and healthy at the same time.
For those in relationships, both new and old, the importance of a living expense conversation cannot be under estimated. Given I am discussing living expenses and how they impact a home loan, these discussions are best held before entering a joint home loan agreement.
How do banks calculate living expenses?
Despite what you may have heard, it is not up to banks to calculate your living expenses. Living expenses for a home loan are yours to calculate. You advise the lender.
Banks have backstops built in to their borrowing capacity calculators. These ensure there is a baseline minimum monthly living expense for each home loan application. Lenders use this baseline to prevent flag very low declarations and avoid loans being approved beyond someone’s borrowing capacity.
The baseline measure of living expenses used by multiple lenders is guided by the Household Expenditure Measure (HEM), researched and published by the Melbourne Institute. By taking into account information contained within a home loan application, lenders can use the HEM guide to guard against lending too much because of under estimated living expenses.
Tips for calculating living expenses
A common way to estimate living expenses for a home loan is to start by looking back at what you have spent. If you mostly spend through one account, then the average of the last three months spend can serve as a good guide to your monthly living expenses.
As confronting as this exercise might be to some, it can be equally enlightening and energising too.
If your goal is to get home loan ready, then an understanding of living expenses go hand in hand with the home loan approval process.
Several banks have online banking apps that can categorise spending. This is especially useful if all your spending is through accounts at one bank.
If you operate accounts at multiple banks, then the are some time-saving apps that can bring all your accounts, and a breakdown of your spending, into one place.
When looking at living expenses for a home loan you can get quite granular, but a home loan application generally requires the following categories covered.
What to tell the bank about your living expenses
When you apply for a home loan, lenders want to know what living expenses they need to allow for so you can live a reasonable lifestyle after the loan has been established—your projected living expenses.
This will help them determine an affordable loan amount for your situation.
The reason for a home loan living expense declaration, for both bank and borrower, is to avoid a situation where a borrower cannot afford repayments and needs to sell their home.
Below is an illustration of how current living expenses can differ to projected living expenses.
The purpose of this illustration is to highlight that it is okay to factor in anticipated changes to living expenses. This is an example only – not something to be copied because your living expenses will be unique to your situation.
It is acceptable for some estimated living expenses to increase and others either reduce or cease—if it seems reasonable and can be justified.
There is plenty of wrong information published that promotes tightening of spending in the lead up to an application—just to get a loan approved.
This approach ignores why living expenses are important, and seems laser-focussed on buying a property, seemingly at any cost—the biggest of which could be getting a loan that cannot be afforded.
Common mistakes with living expenses
Mistakes are best avoided when it comes to a home loan application. They can delay, confuse and risk time-related penalties for the borrower. Here some mistakes I have seen that relate to living expenses for home loan applications.
Overstate living expenses
An over estimation of living expenses can result in a declined application or a borrowing limit below what is desired.
This situation usually arises when a borrower incorrectly presumes they will qualify for a loan, without understanding how significant living expenses are in the assessment.
Sometimes they will incorrectly include discretionary items not intended to form part of their ongoing living expenses—like a one-off overseas holiday. A discussion with an experienced lending professional can help a borrower understand the detail required around living expenses for a home loan.
Understate living expenses
In some cases, understating living expenses can see borrowers ignore the fact they have spent more than they have earned for the past 12mths.
There may be reasons for this, like dipping into capital for home renovations, as opposed to being purely lifestyle-related. Living expenses that seem grossly understated, and also fall below the backstop (HEM), without a good explanation can make it difficult for lenders to approve a home loan.
Ignoring living expenses
We touched on some areas that can impact on living expenses. If new expenses are expected, say a new family member is coming soon, any related expenses should be allowed for.
Similarly, forgetting living expenses can be an oversight lenders can find difficult to ignore, like private schooling fees.
Final word
Preparing to be eligible for a home loan requires careful planning and consideration. One of the key factors that lenders consider when assessing your eligibility for a home loan is your living expenses. It is important to be transparent and accurate when disclosing your living expenses to the bank, as mistakes with living expenses can affect your home loan application.
I have covered a range of topics related to living expenses for a home loan, including how to calculate your living expenses, what types of living expenses are considered, and what to tell the bank about your living expenses. We have also discussed benefits of knowing your living expenses that can extend beyond home loan applications.
By understanding how living expenses and borrowing capacity are related, you can better prepare for a home loan application now.
I consider three areas as essential for borrowers to understand in their preparation for a home loan application. Here are three free articles to bring you up to speed:
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