How Interest Rates Impact your Borrowing Capacity

Higher interest rates make it harder for borrowers to qualify for larger loans or even loans of any size. That's because for every increase of 0.50 percentage points in interest rates, the average person's borrowing capacity falls by about 5%, according to PropTrack senior economist Paul Ryan.

Since 2022, the Reserve Bank of Australia (RBA) has increased official interest rates by 4.25 percentage points, thereby reducing the average person's borrowing capacity by about 40%.

If and when the RBA starts cutting rates, borrowing capacities will rise. In the meantime, the banking regulator, APRA, could achieve the same outcome by reducing a thing called the mortgage serviceability buffer.

Currently, to protect borrowers and the banking system, lenders need to add a buffer of at least 3 percentage points when assessing someone’s ability to repay a home loan – so if, hypothetically, you applied for a loan with an interest rate of 6.20%, lenders would assess whether you’d be able to make your mortgage repayments if the rate rose to at least 9.20%.

If APRA reduced this buffer requirement to say 2.5 percentage points or 2 percentage points, the assessment rate on the hypothetical loan mentioned above would fall, thereby increasing your borrowing power.

Sample 1: Borrower's Perspective

Situation: John is a first-home buyer looking to secure a $600,000 loan. With the current mortgage interest rate at 6.20%, lenders assess his ability to repay the loan at an interest rate of 9.20% due to APRA’s 3% serviceability buffer.

Impact:

• If APRA reduced the buffer to 2.5%, John’s assessed repayment ability would be calculated at an interest rate of 8.70%, potentially increasing his borrowing capacity.


• However, APRA has decided to maintain the 3% buffer, limiting John’s capacity to borrow a higher amount.

Sample 2: Borrowing Capacity Analysis

Scenario:
Since 2022, the Reserve Bank of Australia (RBA) has increased interest rates by 4.25 percentage points. Based on PropTrack senior economist Paul Ryan's analysis:

• Borrowing Capacity Decline: For every 0.50% rise in interest rates, borrowing capacity falls by 5%.


• Calculation:
  4.25% ÷ 0.50% = 8.5 x 5% = 42.5% decrease in borrowing capacity.

A potential borrower who could qualify for a $1,000,000 loan in 2022 may now only qualify for around $575,000.

Sample 3: Regulatory Decision Context

Analysis:
APRA’s decision to keep the serviceability buffer at 3% stems from the following considerations:

• Household Debt: High levels of indebtedness among Australian households.


• Economic Pressures: Persistent cost-of-living increases and a weakening labor market.


• Geopolitical Risks: These factors contribute to financial system stability concerns.

While reducing the buffer could stimulate borrowing capacity, APRA's stance reflects its priority on financial prudence amid uncertain economic conditions.

Sample 4: Future Prospects

Outlook:

• RBA Rate Cuts: If the RBA begins to lower official interest rates, borrowing capacity will naturally increase as repayments become more affordable.


• APRA Flexibility: Should APRA decide to lower the buffer in the future, borrowers could gain more immediate relief, boosting loan approvals even without RBA intervention.

For now, borrowers must navigate tighter lending conditions until economic or regulatory changes ease these constraints.

However, APRA recently ruled that it would keep the buffer at 3 percentage points. “In reaching the decision to keep the settings steady, APRA took account of high household indebtedness and a pick-up in credit growth, persistent cost-of-living pressures, a weakening jobs market and heightened geopolitical risks,” the regulator said.

This article was originally produced by Dawn Inanli from FinPeak Finance.

 

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