Ever heard of the term borrowing power? Ever wonder what it is and how it affects you and your finances? If you answered yes to these questions, you should read on.
Managing budgets and understanding the nitty-gritty of financing can seem overwhelming, particularly for first home buyers without much experience. After all, no one teaches you how to buy a house while you’re still at school! So, it’s not surprising that many first home buyers are unsure of the industry terminology associated with home loans
According to a survey carried out by mortgage lender ME Bank, 61% of first home buyers failed a basic property-buying literary test. But fear not! By educating yourself on some of the home loan basics, you’ll gain more confidence when it comes to applying for a home loan.
For example, do you know how to calculate borrowing capacity? Understanding the concept of borrowing power will bring you one big step closer to achieving your long-standing dream of homeownership.
Understanding Borrowing Capacity
What does the term “borrowing power” actually mean? And how does a lender calculate the maximum borrowing capacity?
In this post, we’ll be breaking down the borrowing capacity formula lenders use to calculate a person’s buying power. We’ll also discuss some common factors that could affect your buying power (for the good or the bad!) and some practical tips on how to improve your maximum borrowing capacity.
What Is Borrowing Power?
Before we launch into the specifics of how to calculate borrowing capability, what does the phrase “borrowing power” actually refer to?
Borrowing capacity refers to the maximum amount of money a person can borrow from a lender, considering their current financial circumstances. It’s determined by factors such as your gross income, existing commitments, estimated living expenses and potential new commitments. Lenders will use a borrowing capacity formula to determine your ability to repay a loan without jeopardising your financial stability.
The maximum borrowing capacity formula plays a pivotal role in mortgage applications, guiding lenders and borrowers alike. It is designed to ensure responsible lending practices and realistic financial goals—in other words, to prevent a lender from loaning someone more money than they can realistically afford to pay back.
How Will Borrowing Power Impact Your Home Loan Application?
Calculating how much you can potentially afford to borrow involves an analysis of multiple financial aspects of your life. One of these is your debt level relative to your income stream. Or, in simpler terms, how much you make versus how much you owe and spend.
Lenders place a great deal of emphasis on this borrowing capacity formula. But first home buyers should be equally interested in accurately determining their maximum borrowing capacity.
Knowing how much you can realistically borrow protects you from losses that may arise if you’re unable to meet your repayment obligations. A consistent failure to pay your home loan obligations could ultimately result in you losing your home.
How To Calculate Borrowing Power
A common misunderstanding about the borrowing capacity formula is that it can be influenced by how much you have in savings or how much equity a borrower may have in an existing property. But here’s the caveat: Your maximum borrowing capacity has nothing to do with those things. It’s solely based on your income and your expenses.
If that comes as a surprise to you, then you’re certainly not alone. In the video below, our founding director, Zain Peart, will walk you through the process of how to calculate borrowing capacity.
When it comes to calculating your maximum borrowing capacity, it’s always a good idea to consult with a trusted expert. A mortgage broker can assess your circumstances and provide an accurate assessment of your borrowing power. This estimation will be based on the latest borrowing capacity formula used by lenders.
Factors to Consider When Using a Borrowing Power Calculator
The most influential factors that will affect your maximum borrowing capacity are your gross income, existing commitments, and living expenses.
Gross Income
Gross income is your total earnings before any taxes or deductions are made. When you look at the payslips you receive from your employer, it’s the total amount listed as “gross pay”.
However, a person’s gross income won’t necessarily be limited to what they receive from their current place of employment. It can also include the following:
- Overtime income that is regular and ongoing
- Bonus income
- Commissions received over at least 1-2 years
- Tax-free income (e.g., Family Tax Benefits A and B)
- Rental income from investment properties
Existing Commitments
Existing commitments are payment obligations a person enters into via an agreement or contract with another party. They’re any payments that you’re required to make regularly. These existing commitments may include:
- Existing mortgages
- Credit card debts
- Personal loans
- Car loans
Living Expenses
Your living expenses are essentially what you spend on food, clothing, transportation and other basic items you need to live. Your cost of living and living expenses are basically the same thing – the amount of money needed to cover your basic needs and to live a certain way.
Living expenses are calculated by lenders using a tool called the Household Expenditure Measure (HEM). The HEM represents the average dollar amount your household spends annually and helps determine your available income for repaying a home loan.
Other Factors
What other factors come into play when using a borrowing power calculator? Lenders will also want you to include the following details when utilising the borrowing capacity formula:
- Buffer
Also called an interest rate buffer, this is when lenders add a percentage to the offered interest rate. Lenders use this buffer to see if you can still afford to pay for your loan, even if the interest rates increase. Typically, most lenders will allow for a buffer of around 2.5% when calculating borrowing power. However, this buffer rate can be higher in times of rising interest rates (like we saw in 2023).
- Surplus
As the word implies, this is the amount of money you have left over after all your financial obligations (living expenses and existing commitments) have been met.
- Tax/Medicare
These are calculated differently for each person, depending on your circumstances. The Medicare tax levy can be affected by your income, the income of your spouse and whether or not you’re eligible for an exemption.
- Negative Gearing
Negative gearing is when you have an investment property that’s costing you more than it’s earning. For example, you might have an investment property that earns you $2,050 per month in rent, but the mortgage and maintenance cost you $2,200. So, instead of earning money from your investment, you’re operating at a loss.
A borrowing power calculator can give you a basic estimate of your maximum borrowing capacity. However, bear in mind that online borrowing power calculators should be used as an approximation only, since their advice is generic. For a more accurate and detailed assessment of your borrowing power, book an appointment with a mortgage broker.
What is the Borrowing Capacity Formula?
Now you know what factors will affect your maximum borrowing capacity. But that still leaves the question: How is borrowing power calculated? Lenders use a calculation known as the borrowing capacity formula. It works like this:
Gross income – (tax + existing commitments + new commitments + living expenses + buffer) = monthly surplus.
How Does the Borrowing Capacity Formula Work?
What does the borrowing capacity formula look like in a real-world scenario?
Imagine you’re a prospective homebuyer with a proposed home loan repayment of $2,500. You earn $10,000 per month and pay $2,000 in taxes. Your existing commitments (for credit card debt) are $300, and the Household Expenditure Measure estimates you will need $2,000 for living expenses. Your chosen lender stipulates a buffer of $400.
Applying the borrowing capacity formula above would give you $10,000 – $7,200 ($2,000 + $300 + $2,500 + $2,000 + $400) = $2,800.
Despite the $2,500 proposed home loan repayment, you’d still exhibit a solid surplus amount of $2,800. This would position you as a favourable candidate for a home loan because it shows you can manage the new commitment without straining your financial stability.
However, as mentioned above, lending criteria may vary from lender to lender. We recommend talking to a professional mortgage broker to better understand what borrowing power calculators specific lenders use.
A Common Misconception About Borrowing Power
When calculating borrowing potential, there’s a common misconception that often catches people off guard. This is the mistaken belief that the equity on property that you own will be considered when calculating your borrowing limit. This is incorrect.
To find out more about home equity and the misconception that it can increase borrowing potential, check out the video below.
Boosting Your Borrowing Power: Key Factors and Practical Tips
When it comes to securing a home loan, understanding your borrowing power is crucial. While you may have a general idea of what you can afford, lenders assess multiple factors before determining how much they’re willing to lend.
If you’re looking to improve your borrowing capacity, there are several strategies you can implement to put yourself in the best financial position.
The Role of Your Credit Score in Borrowing Power
Your credit score is one of the key metrics lenders consider when evaluating your ability to repay a loan. A higher credit score signals responsible financial behaviour, while a lower score may indicate risk to lenders. In Australia, credit scores generally range from 0 to 1200, with higher scores making it easier to secure favourable loan terms.
How to Improve Your Credit Score:
- Pay all bills and loan repayments on time.
- Reduce credit card debt and avoid maxing out your credit limit.
- Limit applications for new credit, as multiple applications can lower your score.
- Check your credit report for errors and have any inaccuracies corrected.
- By maintaining a healthy credit score, you increase your chances of getting approved for a higher loan amount at a competitive interest rate.
How Lenders Assess Different Income Types
You should also be aware that not all income is treated equally. While salaried employees often have straightforward assessments, lenders apply varying rules for other income types:
Freelance/Contract Work
Most banks require 1-2 years of consistent contracts. Some may average your past two years, while others might use the most recent year if income is seen as improving.
Bonuses/Overtime
Some banks typically discount irregular overtime by 50%, whereas Westpac may include 100% if it’s consistent for two years.
Rental Income
Some lenders count only 80% of rental income (to account for vacancies), while investment-focused lenders may use 100%.
Government Schemes That Boost Your Borrowing Power
Australian first-home buyers and investors can leverage these programs to stretch their budgets:
First Home Loan Deposit Scheme (FHLDS)
The First Home Loan Deposit Scheme (FHLDS) is an Australian government initiative designed to help first-home buyers enter the market sooner. Under the scheme, eligible buyers can purchase a home with as little as a 5% deposit without paying Lenders Mortgage Insurance (LMI). This significantly reduces upfront costs, making homeownership more accessible.
First Home Super Saver (FHSS) Scheme
The First Home Super Saver (FHSS) Scheme allows first-home buyers to save for a home deposit within their superannuation fund. By making voluntary contributions (up to certain limits), buyers can take advantage of lower tax rates, which can accelerate their savings. When it’s time to buy, they can withdraw these contributions – plus their earnings – to put toward their deposit.
Stamp Duty Concessions
Many states offer stamp duty concessions for first-home buyers, helping to reduce the upfront cost of purchasing a property. These concessions vary by location:
- NSW – First-home buyers are eligible for a full exemption on stamp duty for properties valued under $800,000, significantly reducing costs.
- VIC – A 50% discount applies to properties under $600,000, making homeownership more affordable.
These savings can free up cash for a larger deposit, which may increase borrowing capacity by improving the loan-to-value ratio (LVR) and reducing mortgage insurance costs.
Self-Employed? Here’s How to Maximise Your Loan Potential
Lenders often view self-employed applicants as higher risk, but these steps can strengthen your case:
- Two Years of Tax Returns – Most banks require this. Lower documentation (“low-doc”) loans exist but come with higher rates.
- Reduce Tax Deductions – Claiming fewer deductions shows higher taxable income.
- Use a Specialist Lender – Non-major banks may offer more flexible assessments.
Talk to a Broker About How to Calculate Borrowing Capacity
Now that you have a basic understanding of how to calculate borrowing capacity, you’re one step closer to buying a home!
If the whole process still seems a bit daunting, don’t worry—our mortgage brokers are here to help. At ZEP Finance, we understand how important it is to accurately ascertain your borrowing power. Contact us today so we can help you get started on achieving your homeownership goals.
After studying business and finance at university, Zain initially expected to pursue a career in finance. However, his passion for property and the experience of buying his own home led him to mortgage broking. He began his mortgage brokering career in 2009 and founded ZEP Finance in 2010.
