How do banks calculate if I can afford an investment property?

This article is available in Chinese here.

Owning rental properties is a common kiwi dream. Many of us envision going into retirement with a couple or more of freehold properties under our belts, bringing in a nice amount of money each week to supplement our superannuation payments. Or perhaps just selling the properties off and sailing into the sunset, weighed down by all the cash.

If you’re looking at how feasible it would be to buy your first or an additional investment property, it pays to know how the bank will weigh up your application.

The banks take a conservative approach when stress-testing an applicant’s ability to support a mortgage. This is in line with the lending rules created and enforced by the Responsible Lending Code. While the conservative approach can lead to frustrating outcomes for some, they do it to ensure (as much as possible) mortgage holders don’t overextend themselves and are able to weather high-interest rates and unexpected costs.

What goes into the banks’ decision on whether to approve an investment property mortgage?

Banks stress test a number of things to decide whether a mortgage should be approved, including:

• Calculating mortgage affordability at between 6-7% interest per annum to check the applicant can accommodate interest rate increases. This is for both existing and new mortgages.
• Calculating mortgage for a shorter period. Some banks require an investment mortgage to be paid over 25 years.
• Scaling rental income by 75% to allow for periods of vacancies between tenants and other costs.
• Assuming any current credit cards and overdrafts will be at their limit for the duration, no matter the actual amounts owed or proven behaviour (eg paying it off each month without fail). Therefore the bank calculates an expected monthly expense of 3% of total credit limits. (here’s an article on how Credit Cards affect your lending)

How do you improve your chances of getting your investment property mortgage approved?

• Cancel your credit cards and overdrafts. If that’s not possible, get the limits down to a minimum.
• Pay off any short-term hire/purchase and layby debt.
• Review the rents of any existing investment properties to ensure they align with the current market.
• In line for a payrise? If you are in a position to request a raise then go for it. It’s a conversation many kiwis find hard but even a modest increase in salary gives you the ability to borrow a lot more. A raise of $2.50 per hour is around $5,000 more per year and means you ultimately could borrow around $50,000 more on a mortgage.
• Work hard to pay down your existing mortgage. This means you can borrow more in the future as well as making financial sense in the long run.
• Look for positive cashflow properties, where the rental income is higher than the mortgage and expense costs.
• Look for properties where you can borrow less and then add value by renovating, growing both the capital and the rental income.
• Keep top of mind that you are looking for a good investment, not a home for yourself. What you would personally prefer and what would be a good investment can be very different things.

Ultimately, as you build your property portfolio, you will likely find no problem in growing equity but your income will become more and more of a limitation. While not easy, increasing your income is the most likely solution, as well as keeping your expenses and liabilities to a minimum.

How can this play out in real life?

Let’s look at a couple with a combined income of $150,000. They own their own home and one investment property. They get $25,000 in rent each year from their investment property. They owe $1 million on a 30-year-mortgage, are paying about $25,000 in interest and about the same (in the first year) in principal payments. This comes to about $47,000 per year in mortgage payments.

The couple has two credit cards and an overdraft option for their bank account. They use the credit cards for all purchases as they get reward points but they pay the cards off each month. They don’t feel they need the overdraft but took it when it was offered by the bank. Between the cards and the overdraft, they have the ability to go into $50,000 of debt.

They’re keen to add another property to their portfolio. They’ve done their own calculations and have concluded that with the right property they would be able to cover an additional mortgage of $500,000 and any unexpected costs if necessary, especially at the low-interest rates the bank is currently offering.

But the bank calculates both their current mortgage and any possible additional mortgage by:

• Assuming 6.5% interest to determine affordability.
• Calculating over 25 years not 30 years
• Scaling back rental income to 75% to allow for vacancies and other costs
• The bank then adds up all of the couple’s credit card limits and overdraft allowances, calculating a monthly cost of 3% of the limit total. In this case, that’s $1,500 of expenses a month that the bank is assuming will occur but that isn’t going to eventuate due to the couple’s good spending habits

Given the above, the bank is unlikely to approve an additional mortgage. If the couple were to reduce (or remove) their credit cards’ limits, review the rent for their current home, look at getting a pay rise and find a bank that calculates investment mortgages over 30 years, this could change a no from the bank to a yes.