Borrowing Within Your Means

Considering the recent collapse in the housing market in the United States, the notion of “borrowing within your means” should take on a new meaning.  If take a little time to investigate what happened there you’ll learn that literally millions of people borrowed far beyond their means and when housing prices began to drop like a stone, they were ruined.  A staggering 1.7 million American homes went into foreclosure in 2009 and estimates for foreclosures in 2010 are as high as 1.9 million additional homes going under.

While it is highly unlikely to happen here in Australia, there are some experts who predict declines of up to 10% in Australian home prices in the not to distant future.  Regardless of whether you are buying your first home or your fifth home, how do you determine whether you are borrowing within or beyond your means?

Some consumers make the mistake of relying on the financial institution from which they are getting a mortgage to define their means.  When applying for a mortgage both the income and the existing debt level of the applicant are rigorously scrutinized by the lending institution.  So if a bank or other financial institution says they are willing to loan you $150,000 to buy a home, why not use that entire amount and go for the biggest home you can buy?  

Here in a nutshell is the problem:  there is often a difference between what you can borrow and what you can actually afford to borrow.  What you can borrow – the amount the bank is willing to loan – assumes ideal conditions.  Your income level will remain the same as will your debt level.  But situations sometimes change in ways banks do not consider.
For example, if your current income comes from two wage earners, what is the possibility one of you will go back to school or leave the work force to raise a child?  Suppose one of you or both of you have dreamed of going into business for yourselves?  How secure are your current jobs?  If you’re willing to incur mortgage debt that will leave you with little disposable income at the end of each month based on anticipated pay increases or bonuses, suppose you don’t get them?

All of these potential happenings would reduce your income and negatively impact your ability to meet your debt obligations.  This of course does not include the possibility of increasing debt from unanticipated emergencies.  

Once upon a time financial institutions required a 20% down payment on a home and limited loans to roughly three times an applicants income.  Another rule of thumb was that no more than 28-35% of an applicant’s income should be devoted to housing payments – including both mortgage and property taxes.

Turning again to the United States to learn from the mistakes of others, we now know many financial institutions there relaxed their loan standards to the point of absurdity as housing prices continued to climb with no apparent end in sight.  

While the situation in Australia is still very positive, world wide lowering of interest rates have led to extremely low interest rates on home mortgages.  Indeed, many homeowners in some countries are refinancing their existing homes to take advantage of lower rates.  Australia’s economy is in much better shape than most so interest rates here are creeping back towards more normal levels and home mortgage rates have risen slightly with them.  

However, we have a unique situation here when compared to the United States in that our fixed rate mortgage loans are generally for a period of three years, after which the interest rate can go up.  Our variable rate mortgages – which some experts feel offers the consumer a better long term value – fluctuate based on current rates.  In short, there is no predictability with variable rate loans even though historically they generally have cost consumers less than fixed rate loans.  Right now Australians appear to be opting for variable rate loans, as the fixed rate has increased going into 2010.  

Most mortgage experts here warn that regardless of whether you take out a fixed or a variable rate loan, you need to factor in a “buffer” to protect yourself against the possibility of rising rates.  You’ll need a bigger buffer with a variable rate loan than with a more predictable fixed rate.