Everything you need to know about affordability calculation
The affordability calculation indicates whether a person can finance the purchase of a property in the long term. This is important for the lender, since approving a mortgage only makes sense if the borrower can afford it. But what exactly is the concept behind imputed affordability? And how high can the affordability level of a mortgage be?
What does affordability mean?
The term affordability refers to the relationship between the current financial expenses of a property and the income of the borrower. Affordability is used, for example, by banks (i.e. lenders) to check whether the financial conditions for covering the total cost of owning the home are fulfilled.
What's different about the affordability calculation is that it uses imputed interest rate costs rather than current or actual interest rates. The imputed interest rate ensures that financing is still possible even if interest rates rise to a higher level. The imputed interest rate is generally 5%.
How is the affordability of a mortgage calculated?
The financing of a property is calculated in two ways: Firstly, using the relationship between a property's current financial expenses and the borrower's annual income; secondly, using the loan-to-value ratio (LTV), which is the relationship between the professionally confirmed value of the property (=market value) and the loan amount. The loan-to-value ratio is a maximum of 80% of the property's market value. This means that borrowers must raise at least 20% of their own equity capital for the financing.
When buying a property, the borrower usually takes out a second mortgage as well. For example, at many banks the loan-to-value ratio for the first mortgage on a residential property is up to 66%, while the LTV for the second mortgage is up to 80%. It's important to note that the borrower is obligated to repay the second mortgage, i.e. it must be paid off after a certain period of time.
The following are other factors that are taken into account when calculating affordability:
- The imputed interest rate, which is usually 5%.
- It's important to note that the second mortgage must be repaid within 15 years or by the time the borrower retires.
- Ancillary costs and maintenance costs of 1% of the purchase price.
- Value of the desired property.
- Variable wage components that can be expected long-term are counted differently depending on the borrower.
The level of affordability is key to purchasing a property
Affordability must not exceed 33%. This means that, in order to guarantee that a mortgage is affordable, the monthly or annual costs must not exceed around one-third of the borrower's gross income. For a solid foundation, affordability is calculated using a mortgage interest rate (i.e. the imputed interest rate) of 5% and ancillary costs of 1% of the property's purchase price.
Example of an affordability calculation
In the table below, the affordability calculation uses the example of a property worth CHF 1 million with debt financing of CHF 800,000.
What other considerations should be taken into account with affordability?
Provisions for ancillary costs and any repairs or renovations must also be included in the affordability calculation.
Affordability in old age
The conditions that play a role in affordability change as you get older. A key change is the reduced income you have when you retire, which can lead to a property becoming unaffordable. Consequently, purchasing a property or the current financial situation of the homeowners must be considered carefully many years before retirement. Most banks make homeowners repay 66% of the property's value before they reach retirement age, which is why many lenders have a maximum loan-to-value ratio of 66% shortly before or after retirement.