You might have heard of your mortgage affordability, especially if you’re house-hunting and about to apply for a home loan. You might also think that it’s a case of the lender working out how much money you have coming in and therefore how much you can afford to borrow on a mortgage.
It’s not quite as simple as that, however. Lenders conduct quite a few tests on potential borrowers to make sure that they can carry on paying their mortgage for years ahead so that they don’t lose their home and the bank doesn’t lose its money.
What does affordability mean?
While essentially your affordability is how much you can afford to borrow, it’s not calculated solely by looking at your income.
Lenders look at:
- Your gross annual income;
- Your monthly income after all your outgoings;
- Any bonuses or commission you may receive, although they tend to assume this will vary year-by-year and so only “count” around half of these amounts, and
- Any major outgoings that are set to change within the next year or so, such as a child moving out of nursery to school, or a new baby starting childcare.
Working out your affordability
Lenders use a specific calculation.
The lender works out your maximum loan size
Your lender will calculate the maximum loan amount you could borrow, which is usually 4.5 times your annual gross income. Sometimes this can be five times your income, if you’re in a high-earning profession.
The lender calculates what you can afford in monthly payments
This second stage looks at what you can comfortably afford in monthly repayments. This involves looking at all your income and outgoings, even down to employer allowances, investment dividends and small debts or other financial commitments like phone contacts and gym memberships. An accurate picture of your disposable income helps the lender to arrive at a sensible repayment figure.
Your lender asks how much you want to borrow
The amount you’d like to borrow, as well as the number of years you’d like to pay it off over, also makes a big difference. The longer the term, the smaller the monthly repayments, but too many years means too much in interest in the long run.
The lender will do some stress tests
These aren’t as scary as you might imagine, they usually just involve looking at how your finances would cope with raised interest rates.
The lender finally calculates your maximum loan
You’ll get your maximum loan figure, which will hopefully be good news. On the other hand…
Why can’t I borrow as much as I wanted?
Your lender needs to offer you a loan that you’ll be able to service comfortably. If your repayments are too high, then you could fall into arrears and even lose your home, which is no good for anyone. You might be disappointed, but your lender is being responsible.
What role does your affordability play in your mortgage application?
Your lender calculates your affordability as part of your decision in principle (DIP). You need your DIP before you can make your mortgage application because it’s a form of promise from your lender that they’ll give you a mortgage of a certain size, as long as all your information is correct.
Do you need to know your affordability?
You’ll want to borrow as much as you can, of course, but when you see how your financial commitments affect your affordability, you might decide to reduce your outgoings a bit. This is especially so if you’re borrowing near the limit of your affordability, so you don’t suddenly tip over into unaffordable territory.
