How existing debts affect your borrowing capacity – and should you pay them off before buying a home?

How lenders assess borrowing capacity

When applying for a home loan, lenders look at your overall financial situation to assess your ability to repay a mortgage. Key considerations include:

• Income: Your salary, wages, business earnings, rental income, or government payments.
  
  
• Living expenses: Day-to-day costs including food, transport, insurance, and childcare.
  
  
• Credit history: Your credit score and record of past repayments.
  
  
• Existing debts: Any ongoing financial commitments like credit cards, personal loans, car finance, student loans, or Buy Now Pay Later (BNPL) arrangements.
  
  

Lenders calculate your Debt-to-Income Ratio (DTI) – that is, the proportion of your income used to service debt. A high DTI ratio may reduce your borrowing power or result in your loan application being declined.

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How existing debts affect your home loan eligibility

Here’s how current debts can impact your mortgage application:

1. Reduced borrowing limit

Even if you’re diligently making repayments, outstanding debts are considered a financial liability. Lenders assume you’ll continue making those payments and factor them into their affordability assessment. This can significantly lower the maximum amount they’re willing to lend.

2. Higher risk profile

Multiple debts or high-interest debt (like credit cards) may signal poor money management or financial overcommitment. This could make lenders wary, especially if you're applying for a large home loan.

3. Impact on loan serviceability

Ongoing repayments take a bite out of your income each month. If too much of your income is already committed, lenders may conclude you cannot comfortably meet the repayments on a new mortgage – even if you technically have enough left over.

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Examples

Example 1: one credit card

Applicant profile:

• Single applicant earning $90,000 per year before tax.
  
  
• No dependents.
  
  
• Living expenses: $2,000 per month.
  
  
• No other debts except a credit card with a $10,000 limit (even if not used).

Impact on borrowing capacity: Most lenders assume you could use the full limit of your credit card at any time. They typically factor in 3%–4% of the card limit as a monthly repayment.

So for a $10,000 limit:

• Assumed monthly repayment = $300–$400
• This reduces the income considered available for mortgage repayments.

Estimated reduction in borrowing capacity: $20,000–$30,000

Even if you don’t carry a balance or use the card at all, that $10,000 limit could cut your maximum loan offer by tens of thousands.

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Example 2: credit card + car loan

Applicant profile:

• Couple with a combined income of $150,000 per year before tax.
  
  
• Two children (dependents).
  
  
• Living expenses: $3,500 per month.
  
  
• Debts:
  
  
  • Credit card limit of $15,000
    
    
  • Car loan with a monthly repayment of $600 and $25,000 owing

Impact on borrowing capacity:

• Credit card assumed repayment (at 3.5%) = $525/month
  
  
• Car loan repayment = $600/month
  
  
• Total ongoing debt repayments = $1,125/month

Estimated reduction in borrowing capacity: $70,000–$100,000

This reduces the couple’s serviceable income by $13,500 per year, which greatly limits their mortgage repayment ability. This could be the difference between affording a home in their desired suburb or needing to look elsewhere.

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Should you pay off debts before buying a home?

The answer depends on the type and size of your debt, and how close you are to meeting borrowing requirements.

Reasons to pay off debts first:

• Increase borrowing capacity: Reducing or eliminating existing debts can free up your income, allowing lenders to offer you a higher mortgage amount.
  
  
• Improve credit score: Clearing debts lowers your credit utilisation ratio, which can improve your credit rating and potentially secure better home loan terms.
  
  
• Lower stress and risk: Entering homeownership with minimal existing debt provides greater financial flexibility and peace of mind.
  

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When you might hold off on repayment:

• Low-interest debt: If your existing loan has a very low interest rate and isn't significantly impacting your serviceability, it might be more strategic to retain cash for your deposit or other upfront home-buying costs.
  
  
• Impact on deposit savings: Using your savings to pay off debt could leave you short for a home deposit. In Australia, a larger deposit can reduce your Loan-to-Value Ratio (LVR), avoid Lender’s Mortgage Insurance (LMI), and open access to better rates.
  
  
• Upcoming credit changes: If you're about to apply for a pre-approval, suddenly closing accounts or making large financial moves might raise red flags. It's best to consult with a mortgage broker before making big changes.
  
  

Practical steps to take

1. Check your credit report: Review for errors and assess your credit health.
   
   
2. List all debts: Include loan balances, interest rates, monthly repayments, and terms.
   
   
3. Use a borrowing calculator: These tools can show how different debt scenarios affect your borrowing power.
   
   
4. Speak to a mortgage broker or financial adviser: They can help weigh up whether it's smarter to pay off debt or maintain liquidity for a deposit.
   
   

Existing debt plays a crucial role in shaping your borrowing capacity and financial readiness for homeownership. In many cases, paying off debts – particularly high-interest or short-term ones – can substantially boost your mortgage prospects. However, it’s not a one-size-fits-all decision. The best path depends on your individual financial circumstances, goals, and the current lending environment.

Before making any significant financial decisions, consider seeking advice tailored to your situation. A well-informed strategy now can save you thousands in interest and open the doors to a smoother property purchase down the track.