Whenever potential homebuyers come to us, one of the most important things we do is to help them to determine their borrowing power – that is, how much they can borrow.

This borrowing power – also known as borrowing capacity or loan eligibility – refers to the maximum amount of money that a lender is willing to provide to a borrower based on their financial situation. Each lender will assess how much money they feel a borrower can safely borrow and comfortably repay and this will be the borrowing power they set for that borrower.

When determining borrowing power, lenders will have their own set of criteria. But generally, this includes income, credit score, financial history and, importantly, existing debt.

In fact, your debt can significantly impact your borrowing power. Why? And how? And what can you do about it if you do have debt? Let’s find out.

Understanding the debt-to-income ratio

Debt matters when it comes to your borrowing power. That’s because when you have a large amount of debt to service each month, you simply don’t have as much money available to pay on a home loan.

One of the fundamental metrics that lenders will use to assess your borrowing capacity is the debt-to-income (DTI) ratio. Your DTI ratio is calculated by dividing your total monthly debt payments by your gross monthly income. Lender’s see this ratio as an indicator of your financial health.

As you’ve probably realised, the lower your DTI ratio, the happier any lender is likely to be. A DTI of 7 is generally about the level that banks in Australia are happy with. Non-bank lenders don’t always apply DTI limits because they’re unregulated by the Australian Prudential Regulation Authority (APRA). That being said, they’ll often take DTI ratios into consideration when assessing loans generally.

If you have a lower DTI ratio then you’ll not only be more likely to get a home loan, but you may also get the loan on more favourable terms, for example, with lower interest rates. On the other hand, the higher your DTI ratio, the less favourable your terms might be.

Types of debt and their impact

Not all debts are created equal. In fact, different types of debt can have different impacts on your borrowing power. Here are some common types of debt and their influence on your home loan borrowing capacity.

Credit card debt

Credit card debt is some of the worst debt you can carry. It can significantly impact your DTI ratio, and therefore your borrowing power. Credit card interest rates are typically much higher than other types of debt. Because of that high credit card balances can also hurt your credit score, which further diminishes your buying power.

Credit card debt – including store credit cards – are also the most at risk for defaults. That means lenders view this as the riskiest type of debt to carry.

Personal loans

Unsecured personal loans are the second riskiest type of debt in Australia in terms of potential defaults, while secured personal loans rank 7^th on the list. If you’re looking to take out a mortgage in Australia, you should think twice before taking on a personal loan which can impact your DTI ratio and lower your borrowing capacity. Plus, lenders don’t like them.

Buy now, pay later

Buy now, pay later debts are relatively new in Australia. But these are also a red flag for many lenders. That’s because this credit is often issued to debtors with no credit check. And the multiple lines of credit that you can carry at once means that you might struggle to keep track of them – leading to a greater risk of default.

Auto loans

Car loans are another type of common debt that can affect your borrowing power in Australia. Having an auto loan increases your overall debt, which raised your DTI ratio, which in turn lowers your borrowing capacity.

However, because the car itself generally secures this loan, these types of loans aren’t defaulted on as often and aren’t viewed quite as negatively as other types of loans.

Debt management strategies

To maximise your borrowing power, it’s a great idea to put strategies in place to manage your debt. For example, you might consider:

• Paying down high-interest debt. By focusing on paying down high-interest debt first, you’ll look like a more reliable option to a lender. This will improve your credit score, and you’ll have less interest to pay in the long run too.
  
• Consolidating your debt. In some cases, it could be a good idea to consider consolidating your debt. This allows you to simplify your payments and potentially lower your interest rates. And that means you might find it easier to manage your monthly debt obligations (and look better to a potential lender).
  
  It’s important to mention that debt consolidation might slightly decrease your credit score temporarily. The drop will come from the hard inquiry that appears on your credit report since debt consolidation is essentially a new line of credit.
  
  However, Experian advises that the decrease is normally less than 5 points. And your credit score typically rebounds within a few months.
  
• Avoiding new debt. While you’re in the process of getting a home loan, it’s a very good idea to avoid taking on any new debt. Any new debt will almost certainly negatively impact your credit score and increase your DTI ratio.
  
• Creating a budget. Creating a budget will help you have more control over your finances. And, as a bonus, put you in a position to pay down your debt more quickly. You’ll be able to identify areas where you can cut expenses and save as well.

Get expert help!

Understanding what your borrowing capacity is likely to be is the first step. Give our handy ‘How much can I borrow’ calculator a go for some great starting information.

If it doesn’t come out the way that you’d like, or if you’re worrying about your debt and how this might impact your borrowing capacity, get in touch with our team. We’re here to help you on your road to getting a fantastic home loan!