When you apply for a home loan, your lender will stress test to see if you would be able to cope with larger repayments should interest rates rise. Interest rates can be subject to dramatic changes, and lenders want to protect themselves from the risk of default. These stress tests also indirectly measure how well you would cope with sudden adverse changes to your income or expenses, since they make your repayments larger relative to your disposable income.
You might be aware of the 3% serviceability buffer that APRA currently expects banks to test applicants against. What you might not know is that this is one of two measures lenders can use. Typically, applicants are assessed against the higher of either their rate plus the serviceability buffer, or the minimum floor rate of that particular lender.
For example, let's say you are applying for a home loan with CBA, with a 4% interest rate. Applying the serviceability test, this means CBA will look at your income and expenses and see whether they think you could repay the loan at a 7% interest rate. At the time of writing, CBA’s floor rate is 5.25% p.a. Since this is lower than 7%, your application will be judged on whether you could make your repayments at a 7% p.a rate. Conversely, if your loan was 2% p.a. (we might get there one day!), the buffered rate would be 5%, so you would be assessed against the higher floor rate of 5.25% p.a.
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What are the floor rates at Australia's biggest banks?
APRA used to enforce a mandatory 7% floor rate as well as serviceability rate, but removed this in 2021. As of March 2023, these are the floor rates at the big four and a selection of other large Australian banks.
| Bank | Floor rate |
| CBA | 5.25% p.a |
| NAB | 4.95% p.a |
| Westpac | 5.05% p.a |
| ANZ | 5.10% p.a |
| ING | 5.50% p.a |
| Macquarie | 5.30% p.a |
| BOQ | 5.35% p.a |
Correct at time of writing.
You’ll note that these rates are all significantly lower than 7%. Since credit is the operating activity of a bank, they will tend away from overcaution when issuing loans. While APRA is mostly concerned with the macroeconomic effect of an increase in default rates, banks are more worried about revenue. They will run their own analysis, comparing the benefits they will receive from issuing more loans against the cost, and likelihood, of more borrowers defaulting to reach their individual floor rate.
How do floor rates affect borrowers?
Prior to 2021, APRA mandated a serviceability floor of 7% p.a and a serviceability buffer of 2.5%. This was removed when the buffer was increased to 3%. APRA has previously said there is a possibility that the 7% floor rate will be reinstated.
The 3% serviceability buffer has been criticised for unnecessarily restricting credit, particularly with rates so high at the moment. As Shane Oliver of AMP capital points out, applying the 3% buffer to mortgage rates at 6% means applicants are assessed on their ability to make repayments at a 9% p.a interest rate.
“The last time mortgage rates were that high were prior to the GFC,” Mr Oliver told Savings.com.au.
“It seems very unlikely we will go back to anything like that from here."
He said that he saw merit in reinstating the mandatory floor rate in order to bring down serviceability buffers.
In theory, floor rates are designed to protect borrowers from taking on mortgages they cannot afford to pay back. It is designed to be the minimum rate anyone who takes on a mortgage should be able to make repayments at.
Some believe the deficiencies of the serviceability buffer have been spotlighted by the upcoming ‘refinance tsunami’ of the hundreds of thousands of Australians whose fixed-rate mortgages expire this year. With many of these people having taken on their loans with the cash rate at record lows of 0.10%, they will be bracing themselves for huge jumps to their repayments now the cash rate is 3.35%. Had APRA’s 7% floor rate remained in place, it’s likely some of these loans would have been initially denied. Depending on your perspective, this could be construed as both a good or a bad thing.
How else do lenders assess loan applications?
When you apply for a home loan, you will need to provide a comprehensive picture of your income and expenses so your lender can get a good idea of how much you can afford in repayments. Serviceability and floor rates are a means to stress test your loan, but they are not the only extra measures used.
The Household Expenditure Measure (HEM)
The HEM is a benchmark lenders use to estimate living expenses. It incorporates a range of factors about the applicant, including personal details like their age and gender, the area they live, their number of dependants and level of spending (basic, moderate or lavish). For a given borrower, the HEM will give an estimated minimum monthly expenditure. They are then judged against the higher of this figure or their average historical spending.
Debt to income ratio (DTI)
As the name implies, DTI is a means for lenders to capture how big a borrower's debt commitments are relative to their annual income. To calculate DTI, you simply divide the total amount you owe across any loans (personal, car, home etc.) by your household annual before tax income.
Lets you owe $400,000 on your home loan, have $50,000 remaining on your car loan and another $50,000 in credit card debt and personal loans. You earn $100,000 a year before tax. Your DTI would be 5 ($500,000/$100,000).
Many lenders have restrictions on loans for borrowers whose DTI is above a certain amount. ING for example only allows borrowers with a DTI of less than 8 for loans with an LVR below 70%. With an LVR above 70%, ING will not allow borrowers with a DTI above 6.
Picture by Andrea Picquadio on Unsplash
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