Zach is a well-paid IT professional and has saved hard to pay off his own house, and bought a couple of investment properties along the way. He has done a great job so far and is now ready to expand his portfolio.
Feeling confident about this financial situation, Zach went and spoke to his bank manager about funding his next investment property and was surprised by the response.
“Sorry, Zach,” the bank manager said, staring at his screen. “You can’t borrow another $400,000”
“What?! Why? I know how it works, both my wife and I earn good money, we have rental properties, and I have more than half of my wage saved every month” Zach started demonstrating his strong financial position. “I can make the repayment quite comfortably. What do you mean I can’t borrow? “
“It’s not as straight forward as that, your new limit is only around $200,000 based on our formula.” The bank manager looked at his system again and told Zach the result authoritatively.
Zach can’t understand why on earth the bank won’t lend him as much as he thinks he is capable of servicing every month and wonder if he has done anything wrong. Have you been in a similar situation? Have you ever wondered how the banks really determine how much you could borrow?
Well, there is a formula that is key to making money in property, and that is the ‘DSR’ formula, which stands for ‘Debt Service Ratio’.
The DSR formula is the main formula that is used by Australian lenders to determine how much money you will be able to borrow in order to buy residential property. While different lenders have slightly different application of the formula, it can be summarised as a way that the lenders use to work out your ability to meet your debt obligations. Here is the actual formula:
It looks easy, doesn’t it? However as mentioned, different banks have different interpretations of this formula and the ‘devil is in the detail’.
Now, let’s break the formula down now.
‘Annual total loan repayments’ – when calculating the loan repayments, the bank will covert your interest only investment loan to a principle and interest loan, and add 2% (sometimes higher) to the actual interest rate to end up what’s called the ‘benchmark rate’, which is used to assess your serviceability.
Let’s say you are applying for $500,000 interest only at 5% per annum, you are actually paying $12,000 interest a year, however the bank assesses your ability to make the repayments based on principle and interest at 7% interest rate. This means that the bank builds a buffer of $7,160.76 a year to allow for any interest rate fluctuations.
|Loan Amount||Type of loan||Interest Rate||Annual Repayments|
|$500,000||Principle & Interest||7%||$19,160.76|
‘Annual total eligible joint income’ – this part is made up of two components:
- Your gross wages – banks only take 30% of your gross wage as the assumption is that the remainder of your wage goes to tax, living expenses and buffer for the bank.
- Your rental income –banks will consider 80% of your rental income as the assumption is that the remainder will be consumed by the cost associated with holding the investment property.
Now the formula looks like this:
I don’t want to bore you to death by further analysing the numbers here, however below are some key points I would encourage you to consider:
- Your actual ability to service the loan repayments does not equate to how much the banks will lend you; they have built-in buffer when working out how much they would lend to you as an investor.
- In the long term, the rental from your investment properties will ultimately determine how many properties you could buy, not your actual wages as only 30% of that is considered by the bank.
- Although the DSR concept and formula is relatively easy to understand, every lender has different application of the formula to match their internal lending policy.
The key objective is to help you understand, at a high level, what the banks are looking for when calculating how much money they could lend you and more importantly, having this knowledge should help you to determine specially what types of properties you should target so that you could keep getting the funding from the banks to grow your portfolio.