Understanding the Household Expenditure Measure (HEM) in Australian Home Loans
The Household Expenditure Measure (HEM) is a crucial benchmark used by lenders in Australia to estimate a borrower’s living expenses when assessing home loan applications. This standardized measure provides an estimate of the minimum level of expenses needed to maintain a basic standard of living, based on factors such as household size and location. The HEM plays a significant role in the loan approval process and has become an integral part of responsible lending practices in Australia.
Purpose and Function of HEM
The primary purpose of the HEM is to ensure that borrowers can comfortably meet their living expenses while repaying their home loans without experiencing financial hardship. Lenders use the HEM as part of their assessment of a borrower’s capacity to service loan repayments, alongside other financial factors such as income, assets, and existing debts.
The HEM serves several important functions in the loan application process:
1. Standardization: It provides a consistent benchmark that can be applied across all loan applications, regardless of the lender or the borrower’s individual circumstances.
2. Risk Mitigation: By using a standardized measure, lenders can reduce the risk of approving loans for borrowers who may have underestimated their living expenses.
3. Regulatory Compliance: The use of HEM helps lenders comply with responsible lending obligations set by regulatory bodies such as the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC).
4. Efficiency: The HEM streamlines the loan assessment process by providing a quick and reliable estimate of living expenses, reducing the need for extensive manual calculations.
How HEM is Calculated
The HEM is based on a combination of data sources, including the Australian Bureau of Statistics (ABS) Household Expenditure Survey and the Melbourne Institute’s Poverty Lines research. It takes into account various factors to estimate a household’s basic living expenses:
1. Household Size: The number of adults and children in the household significantly impacts the estimated expenses.
2. Location: Living costs can vary greatly between urban and regional areas, so the HEM considers the borrower’s location.
3. Income Level: The HEM uses different expense estimates for various income brackets to reflect the tendency for expenses to increase with income.
4. Lifestyle: While the HEM is designed to represent basic living expenses, it does account for some discretionary spending to maintain a modest lifestyle.
The calculation includes various expense categories such as food, clothing, utilities, transport, communication, and some entertainment costs. However, it typically excludes expenses like rent or mortgage payments, as these are considered separately in the loan serviceability assessment.
HEM in the Loan Application Process
When a borrower applies for a home loan, lenders will typically use the higher of either the borrower’s declared expenses or the HEM benchmark. This approach ensures that even if a borrower underestimates their expenses, the lender has a realistic baseline for assessment.
The process generally follows these steps:
1. The borrower provides details of their income, assets, liabilities, and living expenses as part of the loan application.
2. The lender calculates the applicable HEM figure based on the borrower’s household size, location, and income.
3. The lender compares the borrower’s declared expenses with the HEM figure.
4. The higher of the two figures is used in the serviceability assessment, along with other factors like income and existing debts.
5. The lender determines whether the borrower can comfortably afford the loan repayments based on this assessment.
Advantages of Using HEM
The use of HEM in loan assessments offers several advantages:
1. Consistency: It provides a standardized approach to expense estimation across the lending industry.
2. Protection for Borrowers: By using a conservative estimate of living expenses, HEM helps prevent borrowers from taking on loans they may struggle to repay.
3. Efficiency: HEM simplifies the loan assessment process, potentially leading to faster approval times.
4. Regulatory Alignment: It helps lenders meet their responsible lending obligations and align with regulatory expectations.
Limitations and Criticisms of HEM
While HEM is widely used and accepted, it does have some limitations and has faced criticism:
1. Lack of Individualization: The HEM is a generalized measure and may not accurately reflect the specific circumstances of every borrower. Some argue that it doesn’t sufficiently account for lifestyle differences or varying costs in different locations.
2. Potential for Overestimation: In some cases, the HEM might overestimate a borrower’s actual expenses, potentially leading to reduced borrowing capacity for those with frugal lifestyles.
3. Complexity: The calculation of HEM can be complex, and the methodology is not always transparent to borrowers.
4. Regulatory Scrutiny: There have been concerns that some lenders may rely too heavily on HEM without sufficiently considering borrowers’ actual declared expenses.
Impact on Borrowers
The use of HEM can have significant implications for borrowers:
1. Loan Approval: If a borrower’s declared expenses are lower than the HEM, it may affect their borrowing capacity or even lead to loan rejection if the HEM-based assessment suggests they cannot afford the repayments.
2. Realistic Budgeting: The HEM can serve as a reality check for borrowers, encouraging them to consider their expenses more carefully and budget more realistically.
3. Financial Planning: Understanding how HEM is used can help potential borrowers better prepare for the loan application process and manage their finances accordingly.
Alternative Approaches and Future Developments
While HEM remains widely used, there is ongoing discussion in the Australian lending industry about potential alternatives or improvements:
1. Enhanced Individualization: Some propose developing more nuanced models that better account for individual circumstances and lifestyle factors.
2. Integration of Technology: The use of open banking and data analytics could potentially provide more accurate, real-time assessments of a borrower’s expenses.
3. Regulatory Evolution: As lending practices and regulations evolve, the approach to expense assessment may change, potentially leading to refinements or alternatives to HEM.
Conclusion
The Household Expenditure Measure (HEM) plays a crucial role in the Australian home loan landscape. It provides a standardized approach to assessing living expenses, contributing to responsible lending practices and helping to protect borrowers from financial stress. While it has limitations and faces some criticism, HEM remains an important tool in the loan assessment process.
For borrowers, understanding HEM and its role in loan applications is valuable. It emphasizes the importance of providing accurate and comprehensive information about living expenses when applying for a loan. Borrowers should be prepared to discuss their specific circumstances with lenders and, where necessary, demonstrate how their actual expenses may differ from the HEM benchmark.
As the lending industry continues to evolve, driven by technological advancements and changing regulatory landscapes, the approach to expense assessment is likely to develop further. However, the underlying principle of ensuring borrowers can afford their loans without undue financial hardship will remain a cornerstone of responsible lending practices in Australia.
Ultimately, while HEM is an important benchmark, it’s crucial to remember that it’s just one part of a comprehensive loan assessment process. Lenders consider a range of factors when evaluating loan applications, and borrowers should approach the process with transparency, providing as much accurate information as possible to ensure the best outcomes for their financial future.
