For anyone thinking of borrowing to buy a home, it’s important to realise how much you can safely borrow particularly now that interest rates are low and house prices are mostly rising.
According to a paper1 for the Centre of Policy Development and University of Canberra, Australians have an affinity to be over-confident in our ability to repay loans. We also underestimate the likelihood of things potentially going wrong in our lives.
Causes of mortgage stress
A study2 was completed for the Royal Melbourne Institute of Technology (RMIT), which looked at the specific triggers that have resulted in Australian households being unable to meet their mortgage repayments. Survey respondents were asked the initial causes and, if they changed, what the final causes were. They were also able to identify more than one cause. The graph below shows the results.
How to reduce stress
It’s difficult to make borrowing a completely stress free, but there are a few measures that you can take to reduce your troubles
Don’t borrow the maximum amount
Most financial institutions settle on the maximum loan they will offer based on a multiple of your income and other factors. But if you borrow the maximum amount, you may discover you are stretched from day one unless you are very regimented with your finances.
Build up a buffer
It’s not a bad idea to create a cash reserve in a mortgage offset account to provide a buffer that can be drawn upon to meet your loan repayments if you become ill or are not working for any other reason.
Take out mortgage protection insurance
Several lenders offer insurance when you take out a home loan that covers the mortgage (often up to a specified amount and for a particular period of time) if you pass away, become disabled or your employment ends involuntarily.
Take out personal insurances
While mortgage protection insurance can provide ease for a limited time frame, other types of insurances should be considered. These include:
Income Protection Insurance which can replace up to 75% of your income if you are unable to work due to illness or injury. This can ensure you are able to continue meeting the majority of your living expenses, not just your loan repayments.
Critical Illness Insurance which can assist you in servicing or paying off your loan and meeting a range of costs in the event you suffer a specified illness, such as cancer or a heart attack.
Total and Permanent Disability Insurance which can aid you in servicing or pay off your loan and provide an ongoing income if you become totally and permanently disabled.
Life Insurance which can be used to service or pay off your loan and provide your family with an ongoing income if you pass away.
Fix the interest rate
Fixing the interest rate on your home loan can offer protection against rising interest rates. The problem is there are frequently limits on creating extra payments into a fixed rate loan, which would limit your capacity to create a buffer. Many people find a blend of fixed and variable rate loans works best, as additional repayments can be made into the variable rate portion of the debt.
Don’t add fuel to the fire
Over 40% of the people who completed the RMIT survey respond to the initial difficulty in meeting mortgage repayments by using credit cards more frequently than they usually would. Using debt to service debt is very likely to compound the problem.
When problems first start, it’s important to seek financial advice, as there may be a range of potentially viable alternatives to explore. Before you decide how much to borrow you may want to seek financial advice.
1. Source: Understanding human behaviour in financial decision making: Some insights from behavioural economics. Paper to accompany presentation to No Interest Loans Scheme Conference “Dignity in a Downturn” June 2009. Ian McAuley, Centre for Policy Development and University of Canberra.
Source: Mortgage default in Australia: nature, causes and social and economic Impacts. Authored by Mike Berry, Tony Dalton and Anitra Nelson for the Australian Housing and Urban Research Institute, RMIT Research Centre, March 2010.
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