What a broker really does. The 5 C’s of Credit – Part Two
You’ve probably heard of a Mortgage (or Finance) Broker, maybe even used one before, but what exactly do we do? Hint: We don’t just find you the cheapest rate – Google can do that (and it’s probably faster and better at it than we are).
Part Two: Capacity
This follows on from Part One: Character.
So, you’ve read all about how a bank will judge your Character, you’ve gone and got a copy of your brilliant credit score, grilled all your colleagues and neighbours about their account conduct to find they’re all squeaky clean too, and now you’re thinking “sweet, how much can I borrow”?
Well, you could be an angel in the character department, but if you can’t afford to pay the loan back, then the answer to your question is going to be Zero. Zilch. Zip. Enter Capacity. This looks at your ability (nay, capacity) to make the required repayments on a loan without enduring hardship. It’s sometimes referred to as your ability to service a loan, or your servicing capacity.
Accounting cash flows are simple, cash inflows less cash outflows equals free cash flows (or as I like to call it, cash available to do whatever you want with). You’d think banks would also take this simple concept, but unfortunately there’s more (not-so-fancy) formulas involved in this ‘C’ too. Let’s break it down into three sections: Income, Expenses and Liabilities.
So, you’ve got a ripper job, a good salary and a one-of-a-kind boss who actually pays you for the overtime work you do, that’s fantastic, right? Not so much. Banks love consistency, they want to see you earning exactly the same every week, to the cent, without exception.
“But I’m a casual!” I hear you cry. Well, okay, I lied, there are exceptions. Usually that exception involves showing consistency. For a casual this means at least 6 months with your employer. For overtime, bonuses, commissions and allowances it could mean showing that you receive them consistently for between 6-24 months depending on the nature of your work and the type of payment that it is.
Even then, after you’ve worked your guts out to get that $10k bonus every year for the last few years, banks still aren’t going to consider all of it. Nope, more than likely they’re only going to use around 80% of it because they’re scared that once they give you the loan, you’re going to slack off at work and earn less next year. Ok, that’s not really the reason, but they’re giving you a 20-30 year loan typically, who knows if your company will still provide bonuses in 5 years’ time, or if you’re even going to be there. It’s hard to predict the future.
Likewise, with rental income and investment income such as dividends and managed funds, these incomes are prone to fluctuations, so again, banks will not consider everything you earn from these investments, but likely around 80%.
A very hot topic recently. Over the years banks have used many different methods for calculating your expenses, from simply asking you, to using the Henderson Poverty Index, then the Household Expenditure Measure, and now to the painstaking detail of picking apart your every swipe of your card, every transfer and every cash withdrawal.
Banks are still in the mindset of consistency, they think because you spent $200 on take away last month that means you’re going to spend $200 on take away every month for the next 30 years. When people have loans, they change their spending habits, it’s ingrained in us. Banks fail to appreciate that, they focus on the past, digging into your life and what you spent and assume it’s going to be exactly the same forever.
Sometimes, this gets ridiculous, with some banks asking for a breakdown of up to 13+ categories such as “personal hygiene”, “meat and vegetables” and “other groceries”, as though we pay for our deodorant, carrots and cereal all with different swipes of our card so we can keep track of it. It just doesn’t happen that way.
Don’t even think about rounding your expenses either – declare $150 on petrol in your application and when the bank goes through your accounts and find 3 months ago you spent $163, questions will be asked!
This is possibly the trickiest part of putting together a loan application with so many variations between lenders on categories and how far back they want to see your accounts. (See my other article on why this is an inefficient way of tracking expenses).
So, we’ve carved out a chunk of your income and come up with a smaller figure than what you’ve actually earned, then we’ve analysed your every transaction and worked out just how much you spent over the last little while, and now we have whatever is left. Different banks have different terms, but for this article let’s call it your Income Available to Service (IAS).
So what happens with your IAS? First, let’s take all your existing debts – Credit Cards, Store Cards, Personal Loans, Car Loans and Home Loans, and assign a monthly repayment amount. For Credit and Store Cards this is typically 3% of your limit. Why 3%? Most providers require you to pay a minimum amount each month, this minimum is usually 2% of what you owe, so banks use 3% in your application because, well, they can.
If you have any existing Home Loans, you will usually need to provide your limit, your monthly repayment and how long is left on the loan term. Then those not-so-fancy formulas come into play again and each bank is different. Some will work out what your repayments would be if the interest rate were 7-8% and deduct that from your IAS, others will take what you actually pay each month then add, say, 20-30% to it. Every bank is different, but the important thing to note here is that it’s always going to be higher in your application budget than what it is in real life – just like the credit card repayment.
Next, any Car or Personal loan repayments – these are normally just budgeted in as whatever the actual repayments are. I know, I know, where’s the consistency now?
Lastly, your new loan! After all of the above, is there enough left over to pay your new loan? Again, this isn’t “can you pay the actual repayments?”… it’s more like “is there enough to pay the actual repayments plus whatever buffer we use?”.
If after all that slicing and dicing, the answer is yes, then happy days! You can afford your loan according the banks. But even then, some banks will impose a “minimum leftover” even after all of that!
How does your broker help?
You can see this is probably the trickiest bit of your loan application, and each lender uses different formulas on the liabilities and different criteria on what income to accept or not. So, once we know all about your income and expenses, we can find a bank that is going to fit with your circumstances. We do all of those calculations for the bank as well as sit down with you and go through your expenses properly – it’s surprisingly rare for people to know what they actually spend month to month and the following tool can also help. It can not only help you to understand where your money is going, but your broker and/or your bank to understand, too.
Pro tip: Try living as frugally and consistently as possible (without sacrificing your quality of life) for a few months leading up to your loan application. This has three distinct benefits: 1) You’ll save more in that time and need to borrow less. 2) You’ll build even better financial discipline than what you have now, which will likely continue into the future. 3) Your expenses will be lower on your application and much easier to distinguish if you’ve done it consistently.