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Small Pay Rise Can Diminish Borrowing Power for Homebuyers
In a surprising twist, a slight salary increase can lead to significant reductions in borrowing capacity for homebuyers in Australia. A recent case highlighted this issue when an individual experienced a near $30,000 cut in borrowing power after receiving a modest pay rise of just $2,500.
Understanding the Household Expenditure Measure (HEM)
Mortgage broker Mohammed Jomaa from Berti Financial explained that this phenomenon is largely attributed to the Household Expenditure Measure (HEM). This benchmark is used by banks and lenders to estimate an applicant’s monthly spending, and it’s known to create complications under certain circumstances.
For instance, a client earning $127,500 annually could borrow approximately $980,362, based on an initial HEM estimate of $2,852 per month. However, with a pay rise to $130,000, the estimated HEM increased to $3,183, thereby lowering the maximum borrowable amount to $951,625. This resulted in a total decrease of $28,737 in borrowing power, highlighting how a small increase in income can unexpectedly push an individual into a higher expenditure bracket, which varies across lenders and is not publicly disclosed.
Normally, more substantial pay hikes—over $10,000—do not trigger such drastic changes since they afford the borrower greater financial flexibility despite higher HEM categorizations. The real concern arises when pay increases correlate with inflation, as they often do, causing a greater burden on borrowers.
Components of the HEM
The HEM covers essential non-discretionary expenses, including rent, utility bills, groceries, fuel, healthcare, and family-related costs. This metric is derived from the Australian Bureau of Statistics’ Household Expenditure Survey, conducted every six years, and it is adjusted quarterly to keep pace with inflation.
When applying for a mortgage, borrowers must provide an estimate of their living expenses. In most cases, lenders will compare this estimate against the HEM figure and will opt for the higher of the two. Thus, if a borrower’s self-reported expenses are lower, lenders revert to using the HEM, which may not accurately reflect their financial situation.
Jomaa raised concerns about the fairness of this practice, arguing that it lumps together borrowers with varying financial habits. For instance, individuals living well below their means might be unfairly restricted by the HEM, despite rigorous budgeting.
Potential Risks of the HEM
On the other hand, the HEM system is not without its critics. During the Royal Commission into the banking sector, it was viewed as inadequate for verifying actual living expenses. There were instances where borrowers under-reported their expenses, resulting in lenders relying on HEM figures that could lead to borrowers being approved for loans that they could not realistically afford.
In particular, ANZ was criticised for its high reliance on the HEM formula, with over 70% of mortgage applications approved automatically through this method. In response to the scrutiny, ANZ’s then-CEO pledged to shift this reliance to only one in three applications. Likewise, Commonwealth Bank committed to using HEM for approximately 50% of applications.
The Way Forward for Borrowers
The situation underscores the importance of lenders obtaining accurate living expense estimates from borrowers rather than solely depending on HEM. This approach would encourage greater financial transparency and could help borrowers avoid undue stress regarding mortgage payments.
In summary, while a pay rise may typically suggest increased borrowing potential, the complexities of the HEM can inadvertently constrain borrowing power, especially for those receiving smaller salary increases. As the lending landscape evolves, it may be imperative for both borrowers and lenders to engage in more thorough financial assessments to ensure a fairer, more accurate approach to lending.
This summary elaborates on the implications of the HEM while touching upon the finer points of mortgage lending practices in Australia. It highlights the need for both accurate borrower disclosures and lender sensitivity in applying measures like the HEM.
