Home loan buzzword explained: What is the Household Expenditure Measure?

Your living expenses play an important part in how big your home loan should be (or even if you can afford one). One common way lenders assess people’s basic living expenses when considering home loan applications is known as the Household Expenditure Measure (HEM), which came under scrutiny during the recent banking royal commission.

While the royal commission’s final report did not recommend scrapping the use of the HEM, it has led to banks being careful with how much they rely on this basic living expenses benchmark. Let’s take a look at what the HEM is and the controversies around it.

What is the Household Expenditure Measure (HEM)?

The HEM is a standard benchmark that some banks use to estimate people’s annual living expenses. This calculation can be used to assess people’s borrowing capacity, to help determine if they can afford the home loan they’re applying for. The use of the tool has been criticised because of concerns that people were being approved for loans they couldn’t afford to repay.

The HEM benchmark, developed by economic research group the Melbourne Institute, is part of the calculation that some banks use to determine how much you could afford to borrow. It is based on your income, location, family size and type of lifestyle (student, basic, moderate or lavish) which determine an estimate of your expenses.

The main controversy around the use of the HEM stems from the fact that there can often be a difference between a borrower’s estimated and actual expenses, which could result in borrowers struggling to meet their repayments if approved. Analysts at investment bank UBS estimated that Australian lenders used the HEM in up to 80% of all home loans they approved in 2017 .

What problems did the banking royal commission reveal about the use of HEM?

While there were already concerns from lending regulators about the reliance on the broad Household Expenditure Measure tool, the grilling of one of Australia’s largest banks at the banking royal commission in late 2018 revealed how shortcuts were being made in loan approvals and living expenses were being underestimated in some cases.

ANZ was found to have defaulted to using HEM in 73% of cases, instead of doing a deep dive into borrowers’ expenses. The bank has since reduced its reliance on the tool, as have many others, after the banking royal commission found HEM was more useful to assess border-line borrowers and it did not show the full picture of a borrower’s income and debt. The final report stopped short of pushing for the HEM to be scrapped altogether, after several lenders had already started to move away from it.

The Australian Securities and Investments Commission (ASIC) is considering making changes to its responsible lending guidelines in the wake of the royal commission. It released a consultation paper in February in which it argued the HEM benchmark failed to factor in a person’s income appropriately. The Australian Prudential Regulation Authority (APRA) has also taken a tougher stance on lending in recent years.

What types of living expenses will be considered in my home loan application?

Since the royal commission, banks have been screening home loan applications more thoroughly, as a general rule. This has been making it more difficult for some potential homeowners to be approved for a loan. Some applicants have reported that lenders have been looking further than living expenses, scrutinising regular discretionary expenses such as Netflix subscriptions, Afterpay purchases, Uber Eats and gym memberships.

In many cases, lenders are now more focused on household spending than they used to be, meaning applicants may be required to provide more proof of their expenses.

Some common living expenses you may now need to provide an estimate of in a home loan application could include:

  • Groceries
  • Transport
  • Some medical charges
  • Recreation and entertainment
  • Childcare
  • Other regular ongoing expenses

Why are living expenses important in my home loan application?

Whenever a person applies for a home loan, lenders are required by law, under the National Consumer Credit Protection Act 2009 and related responsible lending regulations, to consider their living expenses (among other factors),  in order to provide a fuller picture of their financial situation and whether they’ll be able to pay back the loan.

One way they can do this is through the use of the HEM, which is meant to be used as a benchmark figure only. Lenders are also expected to make inquiries of their own about a borrower’s current income and expenses.

Another measure of living expenses: What is the Henderson Poverty Index (HPI)?

The Henderson Poverty Index (HPI), like the HEM, can be used in banks’ loan calculators to estimate a borrower’s living expenses. It is not considered to be an appropriate way of showing a true reflection of a person’s actual living expenses.

The HPI was used more commonly before the Melbourne Institute developed the HEM in 2011. Back then, many lenders wanted a more current measure based on data on actual expenses, and it was hoped the HEM would be more useful in determining how much a person could borrow, rather than just determining whether they were above the poverty line.

Another criticism of the HPI is that it assumes all households of the same size have similar expense patterns, regardless of income.

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