How do rate rises affect my borrowing power?

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on May 31, 2022 Fact Checked
How do rate rises affect my borrowing power?

ANALYSIS: You may have figured that when interest rates go up, you’ll be able to borrow less. But the situation is more complex than it seems.

You may have gathered that your borrowing power is extremely important when it comes to buying a home. This is because you’ll need to look within your affordability range.

For example, if you get pre-approval from a lender for a $500,000 home loan, and you have a 20% deposit saved up ($100,000), you’ll need to be looking at homes priced at around $600,000.

As you can imagine, when interest rates start to rise, your borrowing power decreases. This is because it becomes more expensive to service the mortgage. Let’s illustrate this with an example.

Jaron wants to buy a home with his partner Carol. Jaron’s gross annual income is $90,000 and Carol earns $65,000, bringing their combined annual income to $155,000. Their combined annual household living expenses are $60,000.

Based on an interest rate of 3.50% p.a. for a 30-year loan term, they should be able to borrow $513,000. But based on an interest rate of 4.50% p.a. (which is a 100 basis point increase), they could only borrow $464,000. This means their borrowing power effectively decreased by $49,000.

But knowledge is power. Let’s discuss how rate rises can affect your borrowing power, and any other obstacles that may be in your way when buying your first (or second or third) property.

What’s happened so far?

If you’re even a little bit clued-in on the finance industry, chances are you know that the RBA recently increased the cash rate for the first time in over 11 years. Now that the central bank has finally pulled the trigger, more shots are expected to be fired in the coming months.

Considering the fact that the cash rate hasn’t risen in over a decade, you may be feeling a little nervous about what the future holds. Whether you’ve just bought a home or you’ve been hoping to hop on the property ladder in the near future, rising interest rates are going to affect you in some way.

Home prices yet to decline materially despite interest rate rises

So far, home buyers have been affected negatively because interest rate rises have not kept pace with home price falls. This means their borrowing power has been lowered, but house prices have remained elevated.

After the May 2022 RBA board meeting, RBA Governor Philip Lowe said the cash rate profile was 1.5% to 1.75% by the end of 2022, and 2.5% by the end of 2023. With the cash rate currently sitting at 0.35%, this hints at the fact we’re likely going to see multiple rate hikes this year.

Many economists have penciled in their best bets on when the RBA will move again. For instance, CBA economists have tipped rate hikes in June, July, August and November in 2022 and then another in February 2023.

While these are just forecasts, we can probably expect something similar given the guidance from the RBA.

Also read: What happened when the RBA last hiked the cash rate?

Handbrakes applied

The prudential regulator APRA also increased its serviceability buffer in late 2021 from 2.5% to 3.0%. This means that if you have a 2% mortgage, your capacity to repay will be assessed at 5%. The half-a-percentage-point increase, APRA estimates, could lower the average borrower’s borrowing power by 5%.

RBA rate rises and APRA serviceability rises act as a handbrake on the home loan and property markets, preventing them from getting too hot and unwieldly.

House price performance

As most of us probably know by now, house prices exploded across Australia over the past two years. In 2021, house prices rose at the third fastest pace in history. While those heady days seem to be behind us - with house prices starting to fall in Sydney, Melbourne, the ACT and more - cities like Brisbane and Adelaide are still on the growth train.

If you thought you were priced out of the market when house price rose, logically you’d be worse off when interest rates go up too. But with house prices seemingly going down, you won’t need to borrow as much which may cushion the blow.

Basically, while rate rises are one piece to the borrowing power puzzle, it’s also indirectly affected by house prices. When house prices go up, you need to borrow more to buy. When house prices go down, you need to borrow less.

Confused? Let’s dive into what borrowing power is, why it matters, and exactly how rising interest rates can change things.

What is borrowing power & why does it matter?

In a nutshell, your borrowing power is how much money you’re able to borrow. Seems simple enough, right? But let’s peel it back a layer to understand how it’s calculated and why it’s important.

When you apply for a loan, your lender will do their due diligence and make sure you can actually afford the amount you’ve applied for. While we’d all love to splurge $30 million on a mansion in Sydney, most of us can’t afford it.

Your lender will look at your financial situation (income, expenses, assets, liabilities and so on) to see how much money you could realistically put towards a mortgage each month. This is what they determine your borrowing power to be.

They will also account for the interest rate you’ll be paying in their loan assessment. They’re also required to factor in APRA’s serviceability buffer or use their own ‘minimum interest rate floor’ to assess your ability to repay a mortgage should interest rates rise. In June 2021 for example, CBA voluntarily increased its own floor rate from 5.10% to 5.25%.

Where to from here?

Looking into the future, we don’t necessarily know what’s to come. We can look at the last time the RBA hiked the cash rate, but things have changed since November 2010. Other factors such as housing affordability and supply and demand imbalances are likely going to shake things up this time around.

Interest rates are highly anticipated to keep rising, but house prices are also earmarked to fall. In a perfect world, these two would balance each other out; even if you’re able to borrow less, you don’t need to borrow as much to buy a home.

Ultimately, we don’t have a time machine. All we can do is guess, and I’m guessing that’s pretty unhelpful.

If you’re ready to buy a home, don’t be disheartened - rising interest rates won’t lock you out of the property market forever. You might need to save a little more or simply borrow less, but there are still ways to find your footing.

Also read: How hard is it to buy your first house right now?


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Rachel is a Finance Journalist, and joined Savings in 2021. Coming from a background in the FinTech space, her interests include the innovation of lending technology, property, investing, and more. With a passion for educating and informing people about their finances, she hopes to increase the financial literacy of everyday Australians.

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