Mortgage applications can be stressful with the level of detailed information requested on the application. Recent banking commission reforms have forced lenders to adopt changes by including more items and being hawkish on living expenses incurred by consumers. So to increase your chances of getting attractive mortgage offers and subsequent approval, it is important to be accurate in self-assessing your living expenses.
Household Expenditure Method (HEM)
Developed by the economic research group Melbourne institute, Household Expenditure Method(HEM) is the standard benchmark lenders use to estimate a loan applicant’s annual expenses. According to UBS, in 2017, 80% of all home loans in Australia were approved using the HEM as a benchmark. The HEM accounts for a range of things such as borrower’s location, number of dependents, and lifestyle standard – student, basic, moderate or lavish. According to UBS, the basic lifestyle estimates is used for the majority of cases but families are likely to be spending much more, arguing that lavish measure would provide a more accurate estimation of expenses.
In the royal commission’s final report, HEM was not found to be a sufficient alternative to verification of borrower’s expenditure. The Royal commission stopped short of scrapping HEM altogether because the lenders had started moving away from HEM gradually. A large bank was probed for using the HEM benchmark to automatically approve 73% of home loans.
How are living expenses calculated by banks?
When applying for a mortgage, many lenders will require an estimation of your weekly or monthly spend on things like groceries, transport, and utilities. It is then expected that the lender will compare the living expenses you provide against the HEM calculations for someone in your location with your number of dependents. The lender may then take the higher of these two numbers (either expense self-declared or HEM calculations matching your situation). Typically, lenders follow the steps given below:
- Identify the expenses based on HEM for the family matching applicant. It is considered unreasonable for someone to spend less than HEM each month.
- Ask the applicant to self-assess living expenses.
- Review bank account statements, credit card statements to verify self-declared expenses.
- Either accept or adjust your self-declared expenses.
- Take the higher of the self-declared expenses or HEM for the family matching the applicant.
How do expenses impact a mortgage application?
Since the banking royal commission, lending requirements have tightened. Lenders take responsible lending requirements seriously and have been rejecting home loan applications without sufficient information on expenses. There are also stories of lenders rejecting a home loan application because the applicant spent too much money on Uber Eats, or had an outstanding Afterpay debt. Lenders are closely scrutinizing expenses matching them with bank statements.
Lenders are required by law, under the National Consumer Credit Protection (NCCP) Act to take living expenses into consideration when someone applies for a home loan. This is to ensure that lenders have considered a complete picture of consumer financial status and whether they will be able to repay the loan. It is expected that lenders do not completely depend on HEM but deep dive into a borrower’s income and living expenses to get a more complete, accurate picture. If you earn $200,000 per year, you will have higher allowable expenses than someone earning $50,000 per year.
Common mistakes when self-assessing living expenses
It is very easy to either underestimate or overestimate expenses. Some of the common mistakes include the following:
- Rental expenses should be ignored if you are buying a property to occupy. Sometimes, the rental expenses get bundled as expenses after settlement but should be excluded.
- Private school fees often get missed out. You may borrow more than what you can afford causing significant financial stress.
- Do not include debt in your expenses. They should be recorded under liabilities.
- Do not include one-off large expenses such as an overseas trip or furniture.
- Do not deliberately underestimate living expenses. The lenders validate expenses against any bank statements/credit card statements. Even if a home loan gets approved, it may push you to financial stress.
- Do not classify business expenses (if you are self-employed) as personal expenses
Correcting mistakes with self-declared living expenses
Unfortunately, lenders may decline your application if they find you cannot afford repayment due to your living expenses. Lenders won’t tell you exactly which part of living expenses put you over the line.
You may have success in correcting mistakes in self-declared expenses by providing a written explanation to the lender that the expenses are no longer regular and ongoing. Ultimately, you are the only one who knows your living expenses.
Debts with other people
If you have debt with other people, some lenders assume as if the debt is 100% in your name. They assume the worst-case scenario that the other person is not paying their share. There are some lenders who may only consider a portion of debt against your name.
Mortgage without partner
If you are in a de-facto relationship but do not include your partner as an applicant, your partner is considered a dependent partner. Expenses of your partner are considered as part of living expenses calculations. However, if you can provide payslips of your partner to prove that your partner is not dependent on you, then lenders may exclude your partner’s expenses as part of living expenses.
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