When you apply for a mortgage, lenders make an assessment for your borrowing capacity. This naturally takes into account both your income and your expenses. They need to know that you will be able to pay off your home loan on top of what you already pay in living costs each month. Under the National Consumer Credit Protection Act, the lender is legally obligated to assess your expenses.

The degree of detail lenders will want when it comes to your expenses will vary. Some will just look for your average expenses over a certain period, while others will want a detailed breakdown of exactly where your money is going.

Lenders will need to stress test your finances to see if your home loan repayments could survive a new car for example, or an additional child. Part of this equation is the Household Expenditure Measure, or HEM for short.

See also mortgage calculator.

What is the Household Expenditure Measure (HEM)?

The household expenditure measure (HEM) is a tool many lenders use to calculate an applicant's basic expenses. It's estimated up to 80% of lenders in Australia use HEM as a yardstick to assess an applicant's borrowing capacity.

The HEM, developed by the Melbourne Institute, is a formula designed to calculate the minimum living expenses for any given individual. HEM is a formula reflecting median spend on absolute basics plus the 25th percentile spend on discretionary basics.

HEM takes into account an applicant's age, the location they live, number of dependants and level of spending among other things. It uses more than 600 data points, including the median spend on groceries, clothes, transport, internet and many other essentials.

The common alternative to the HEM is the Henderson Poverty Index (HPI), but the HEM is more widely used as it takes more data points into account.

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How do lenders use the HEM?

The HEM is usually used as a minimum level of spending for a given home loan applicant. For example, lets say Darryl and Sal live a basic lifestyle in Melbourne with their three dependant children, and are applying for a home loan with a bank. The HEM might estimate that this family will spend $3,100 per month at minimum on non rent/mortgage living expenses. Even if they can show that in the past six months they have only spent $2,500 per month, the bank will take the higher HEM number as the family's typical monthly expenditure.

The bank will not necessarily always take the HEM: they might take the higher figure out of your average expenses or the HEM to determine how much you can borrow.

What is not included in the HEM?

The HEM is an aggregated estimate of all essential living expenses. It includes food, clothing, medical costs among many others. However, there are several living costs that aren't factored in to the HEM. Private health and life insurance, overseas trips, recreational vehicles and adult dependants are all examples of expenses that are calculated separately to the HEM. Any expenditure on these is taken out of your monthly expenses and added back on to the HEM.

Returning to the above example, that $2,500 per month that Darryl and Sal spend might include $300 worth of private health insurance. In this case, the bank would take that $300 and add it on to the $3,100 HEM expenditure, as the HEM does not include private health insurance.

What are basic, moderate and lavish HEM levels?

When calculating the HEM, lenders may classify your spending as one of three levels. Basic, moderate, or lavish.

You may think that your mortgage borrowing capacity is a simple matter of the more you earn, the more you can borrow. It isn't this simple though. Bankers and lenders are aware that generally, the more you earn, the more you spend. Obviously, there are frugal exceptions, but this will usually be the case.

Lavish does not even necessarily mean extravagant. For example, you may work long hours to earn a $150,000 salary a year, but to give yourself the ability to work such long hours, you need to hire an expensive cleaner and nanny.

This could mean that people on large salaries are disappointed by their borrowing capacity, as the HEM might have ruled that they have a correspondingly large monthly spend. If you are in a similar situation, the best thing you can do to increase your borrowing potential, besides a salary increase, is to bring your spending down a category, reducing your HEM estimate.

Why is the HEM controversial?

The HEM has been criticised for underestimating the cost of non essential household goods. Critics have said this has lead to many people being approved for loans they cannot afford. The HEM was highlighted by the Royal Banking Commission, which found that ANZ had defaulted to using exclusively the HEM in 73% of applications. Even one of the benchmark authors of the HEM, Professor Guyonne Kalb from the Melbourne Institute, came out and said banks are not supposed to rely solely on it to approve home loan applications.

Ms Kalb said that the HEM was best used as a comparison tool with declared expenses, to identify households underestimating their expenses. She said that the level of expenditure predicted by the HEM was 'very modest', and so should not replace declared expenses.

The Royal Commission concluded that the HEM should not be used as ANZ had, as an alternative to verifying a borrowers expenditure. However, the commission decided not to scrap the HEM, due to concerns this would make getting a home loan more difficult.

In a separate case involving Westpac though, the courts actually found in favour of the bank using the HEM. In the 'Wagyu and Shiraz' decision, Justice Nye Perram said that a home loan applicants current living expenses were unimportant in assessing their ability to repay the loan.

"[Borrowers] may eat Wagyu beef everyday washed down with the finest shiraz but, if [they] really want [a] new home, [they] can make do on much more modest fare," he wrote.

The court ruled against the Australian Securities and Investment Commission (ASIC), allowing Westpac to continue to use the HEM over declared living expenses.