The prudential regulator APRA on Wednesday ordered banks to lift the “buffer” they add to market interest rates when assessing borrower capacity to repay loans.

Here is what that move will mean in practice for potential borrowers.

What is a serviceability buffer?

Banks are required to examine a borrower’s ability to repay a loan at a higher interest rate than those offered today.

This ensures when interest rates rise, as they eventually will, borrowers aren’t stressed by the higher repayments. The amount that banks add on to the market interest rate is known as the serviceability buffer or Floor Rate or Assessment Rate.

Serviceability tests, known as the interest rate plus the buffer is used by all mortgage brokers and banks to assess loan applications. This used to be set by APRA, but is now set by banks. APRA requires banks to assess potential borrowers based on the higher of the Serviceability rate, or the actual rate plus the buffer.

How is it changing?

APRA said it would lift the buffer by 0.50 percentage points, from 2.5 per cent to 3 per cent. So now 3 per cent needs to be added to the rate on the product offered by the bank. So effective, an example is as follows:

2.50%           Your loan rate

2.50%           Previous Buffer

5.00%           Assessment Rate

With the changes from 01 Nov 2021, your assessment rate will increase:

2.50%           Your loan rate

3.00%           New Buffer

5.50%           Assessment Rate

What will the 50bps rise in the buffer do to average borrowing capacity?

APRA said its increase in the buffer would curtail the borrowing capacity of a typical customer by 5 per cent. That means if you could previously borrow $1 million, you will now be able to borrow $950,000.

However, not all customers borrow at their full capacity. Indeed, at CBA, only 8 per cent of home loan applicants borrowed at capacity over the first half. This means that the new buffer will not impact many borrowers.

According to calculations by Finance Circle Group using CBA’s serviceability calculator, the average family’s maximum borrowing capacity could drop by around $35,000 under the new buffer. This assumes one adult is working full-time and the other is part-time, and they have two dependent children.

A single person on the average income of just over $90,000 will be allowed to borrow about $28,500 less under the new rules.

The average home loan in Australia is about $728,500 as of December 2020, according to the Australian Bureau of Statistics. A 5 per cent reduction in borrowing capacity would drop that to $692,075, reducing the average mortgage by $36,425.

What else might be coming?

APRA is expected to use additional tools to curb bank lending if high levels of lending to indebted borrowers continues despite its higher buffer.

Another option is a debt-to-income ratio cap (DTI), which could limit the number of new loans with a debt-to-income ratio of six times or more. This could prevent borrowers taking on risky levels of debt and curtail investors buying multiple properties. But it could create a barrier for first home buyers unless exemptions are made.

It could also lift the “floor” rate used for serviceability assessments, as described above. The average floor rate for the big four is 5.09 per cent. Lifting it to, say, 6 per cent could see borrowers assessed at that rate, which would kick in over the new buffer rate, reducing borrowing capacity further.

APRA could also revisit investor lending caps, which limit the number of loans that can go to property investors compared to owner-occupiers. This was imposed between December 2014 and April 2018, when APRA limited banks to 10 per cent growth in investor loan books. This reduced the number of investors competing with first home buyers and other owner-occupiers but had limited success cooling property prices.

Another tool used in recent years is interest-only loan caps, which limit the number of new loans where borrowers are only repaying interest – which are popular with investors seeking the benefits of negative gearing tax concessions. Between March 2017 and December 2018, banks were required to limit interest-only loans to 30 per cent of new lending, which reduced the number of investors active in the market.

Loan-to-value ratios caps are another option, and have been put in place in New Zealand, where prices in Auckland have also been running rampant. This limits the number of new loans with small deposits. But they could unfairly target first home buyers, who are struggling to save for deposits given low savings rates, unless exemptions are made.

APRA may also decide to introduce a combination of these tools, all of which will be discussed in a forthcoming paper. It will also consider whether to use new powers granted to it in 2017 to subject non-bank lenders to lending rules.

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We can be a one-stop-shop for your financing needs. Contact us to find out more about how we can help you with commercial and asset finance.

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