Warning: Unsecured debt can hurt your borrowing power
YOU might not realise it, but any unsecured debt you have can reduce your ability to borrow for a home loan.
Unsecured debt refers to any type of debt that doesn't need any form of security to back the loan. Credit cards are a popular example, with Australians currently owing about $32billion on credit cards - an average of about $4200 per cardholder, according to ASIC.
Other examples of unsecured debt include short term personal loans - often called "payday loans” - and student loans. The repayment term of an unsecured loan is usually short - up to five years - although some lenders may offer loans repayable over a longer period.
Any existing debt commitment impacts your ability to borrow for a home loan. Unsecured debts like credit cards are no exception, as lenders assess your loan application based on your income and debt levels.
The higher your level of unsecured debt, the more impact it will have on your serviceability - your perceived ability to repay a home loan.
You might pay off your credit card on a monthly basis, but lenders are more interested in the credit card limit than the balance. Credit limits are viewed as a possible debt level in the future, so lenders will take your credit limit into account when assessing your borrowing capacity - even if the card has a zero balance.
Expect the minimum monthly payment to be assessed as a percentage of the total credit limit. So, you might have a credit card limit of $10,000, but the impact on your home loan will be much greater - as much as $20,000 or $30,000. Multiply this by the number of credit cards in your wallet, and you may be surprised how much it matters.
Here's what to do
Before you apply for a home loan, reduce the limits on your credit cards and close any cards you can do without.
Ensure there is a record of the new limit on your credit card statement. During your home loan application, you will be asked for paperwork like this to show proof of your financials.
If you're planning to borrow for a home loan in the coming year, it's wise to avoid taking out any new debts, whether secured or unsecured.
Secured loans are loans that are backed by an asset like a house or a car. This asset is collateral for the loan. When you agree to the loan, you agree that the lender can repossess the collateral if you don't fulfil the debt obligation.
An unsecured loan doesn't need this kind of security. For this reason, unsecured loans are riskier for lenders and you will often pay a higher interest rate than with secured loans.
Debt is a serious issue that lenders consider when assessing your home loan suitability, but it's unlikely a loan will be declined solely for debt reasons. Instead, your loan may be approved for a lesser amount - so that you can more comfortably keep up with your debt repayments.
Each home loan application is reviewed by lenders on a case by case basis, depending on your circumstance. Lenders will piece together the story of your income, savings, living expenses and debt - and from here work out the level of risk you represent.
If the lender considers your serviceability to be strong, your debt level will have less impact on your ability to borrow for a home loan. Customers who apply to borrow at the upper limit of the Loan to Value Ratio (LVR) will come under greater scrutiny.
To increase your chance of home loan approval, speak to your Yellow Brick Road mortgage adviser. We can help you evaluate your personal situation and choose from a range of home loan options and market-leading interest rates.
This information is general in nature and readers should seek professional advice specific to their circumstances.