- We examine the methods used by lenders to estimate loan applicants’ regular expenses.
- HEM – one of the most common expense calculation methods – explained.
- How to improve your financial situation so that you survive the HEM investigation.
Every time someone applies for a loan from a responsible lender in Australia, the lender will ask for information about the prospective borrower’s income, assets, debts and regular expenses.
Lenders are required to do this by the National Consumer Credit Protection Act, which states that the lender must ‘make reasonable enquiries about’ and ‘take reasonable steps to verify’ the borrower’s financial situation, in order to ensure that they can afford to make the required loan repayments.
One of the ways banks and other lenders assess a borrower’s regular expenses, in addition to asking them to provide details of how much they spend on specified items within a given period, is to use the Household Expenditure Measure.
In this guide
What is the Household Expenditure Measure (HEM)?
The HEM is a method of predicting household and personal expenditure in Australia, based on an individual or couple’s demographic situation – that is, their age, income, whether they’re single or in a relationship, and whether they have children or other dependents.
It is calculated and published quarterly by the Melbourne Institute, a leading economic and social policy research body, as a benchmark based on data collected in the Household Expenditure Survey published periodically by the Australian Bureau of Statistics (ABS).
Henderson Poverty Index as an alternative to HEM
An alternative – or perhaps, more accurately, supplementary – method used by some lenders to calculate basic living expenses, is the Henderson Poverty Index (HPI). This is based on the findings of a government Commission of Enquiry into Poverty led by Professor Ronald Henderson in the mid-1970s, and subsequently updated data.
Although both the HPI and the HEM are based on expenditure data gathered by the ABS, the HPI is less useful because it calculates only very basic expenditure and does not reflect any variations based on income or demography.
HEM expenditure levels
The HEM calculates median expenditure for different types of households on three standard levels:
- Basic. Includes only absolutely necessary expenditure, such as most food items, children’s clothing, utilities, transport and communications.
- Moderate. This level adds discretionary expenditure like take-away food, restaurants, confectionery, alcohol and tobacco, entertainment, and clothing for adults.
- Lavish. Expenses on this level would include household services like a cleaner and a gardener, and regular overseas holidays.
None of the expense levels include rent or mortgage payments, since they are meant to be an indicator of living expenses net of housing costs.
A lender would almost certainly look at the applicant’s income and choose an appropriate expense level, as well as being guided by household demographics.
In other words, a single parent on a low income might be assessed as having the lowest level of basic expenses, whilst a very high income household with several children would be likely to be spending near the top of the scale.
Why the HEM matters
Although lenders will ask loan applicants to provide details of their own expenses – under headings like groceries, transport, childcare, utilities, communication (internet and phone), entertainment, medical, insurance – they recognise that many people will not have an accurate idea of their costs. They will certainly compare the applicant’s estimate of expenses with the HEM indicator.
However, following the Banking Royal Commission in 2017, banks and other lenders have come under scrutiny for relying too heavily on the HEM. That is, the Commissioner thought they should have been able, by looking at bank and credit card statements, to establish that some applicants’ actual expenses were higher than the HEM amount, meaning that they would struggle with loan repayments.
Having said that, the National Consumer Credit Protection Amendment (Supporting Economic Recovery) Bill 2020, which has passed through the lower house and is now being considered by the senate, will, if and when it becomes law, shift some of the responsibility back to the borrower. The lender will no longer have an absolute obligation – just a system in place – to check that loan repayments can actually be afforded.
Whatever happens, the HEM will remain as an important tool used by lenders to decide whether expense details provided by an applicant are likely to be reasonably accurate.
How to prepare your finances to survive HEM scrutiny
So, how can you get ready to prove to your potential lender that your income-to-expense ratio is sufficient to make your proposed loan repayments affordable?
There’s probably not much you can do about your income in the short term (except try not to change employers), but you can reorganise your expenses. Here’s what you should do.
- Cut back on discretionary spending so that you fall into the ‘moderate’ or ‘basic’ band, depending on your income. This may mean reducing the amount you spend on things like eating out, take-away food, entertainment and alcohol.
- Review your subscriptions to streaming services like Netflix and Stan. Do you need more than one? Can you opt for a downgrade that’s cheaper? Are you really getting a benefit from Amazon Prime?
- Look for less expensive utility, phone and insurance plans.
Pay off debts
The fewer debts you need to list on your loan application, the more sensible you’ll look from a financial viewpoint. So in this case, instead of paying off the debt with the highest interest rate first, go for the snowball method of debt reduction to motivate yourself and delete the maximum number of loans from your list.
Improve your credit score
Spending less and paying off your debt will already start to improve your credit score. But there’s more you can do. First of all, make sure you know what your credit score is, by using our free credit score service. Then follow our guide on how to improve your credit score.
Save up for a bigger loan deposit
A good level of genuine savings record is imperative when applying for a home loan. Lenders want to see that you have enough financial discipline to avoid spending all of your income. Once again, following the previous steps listed here will make it easier for you to add to your savings, impress the bank, reduce the amount you need to borrow, and possibly avoid lenders mortgage insurance as well.
The bottom line
No matter which expense calculation method your lender most relies on – HEM, HPI, a close scrutiny of your personal financial statements, or a combination of all three – you need to understand the difference between them and get your finances into the best possible shape before you apply for a loan.