Essentially, the serviceability buffer is a contingency that a lender is expected to apply in the loan application process to give borrowers a fair chance of continuing to make repayments if financial circumstances change.

This includes the possibility of future interest rate increases as well as any unforeseen changes in income or living expenses. A serviceability buffer standard is set by Australia’s banking regulator and generally expressed as a percentage to be added to a loan’s interest rate when home loan applications are assessed.

How is the serviceability buffer applied in the loan application process?

When you apply for a loan, assessors take into account your income, living expenses, any existing debt and measure this against the size of the loan you’re seeking. When banks do this, they’re required to assess whether you’d still be able to make repayments should interest rates go up or if there was an unexpected change in your income or living expenses.

To make an allowance for this, banks must apply a serviceability buffer – a specified number of percentage points on top of the interest rate on the home loan you are applying for. For example, if the serviceability buffer is set at 3% and you are applying for a loan with an interest rate of 6%, the bank must determine whether you’d be able to make repayments if the rate was to rise to 9%.

Alternatively, banks may apply what’s called a floor rate, a set interest rate that applications must be measured against. As an example, if the floor rate is 7%, applicants are assessed as though they will be paying an interest rate of 7% even if the rate of the loan they are applying for is lower. Banks must assess loan applications on whatever rate scenario is higher.

Who sets the serviceability buffer?

The national banking regulator - the Australian Prudential Regulation Authority (APRA) - introduced a home loan serviceability buffer in December 2014. At that time, APRA required banks to assess all home loans against a floor rate of 7% or at 2% above the interest rate to be paid by the borrower – whatever was higher.

The buffer was introduced at a time the Australian property market was running hot and there were high levels of household debt. At the time, APRA said it was introducing the buffer to reduce medium-term risks to financial stability. Since that time, APRA has periodically adjusted the serviceability buffer, taking into account prevailing economic conditions. At the time of writing, the buffer currently stands at 3%, having been lifted from 2.5% in November 2021.

APRA’s serviceability buffer applies to banks, credit unions, and building societies. APRA does not regulate non-bank lenders which are regulated by the Australian Securities and Investments Commission (ASIC). However, non-bank lenders also apply the serviceability buffer to comply with ASIC’s responsible lending laws.  

What is the difference between the serviceability buffer and the debt to income ratio?

The serviceability buffer considers a homeowner’s ability to pay a set percentage above the interest rate of the loan they are applying for.

The debt-to-income ratio (DTI) measures the proportion of debt that a borrower has compared to their income. The ratio helps a lender determine whether a borrower can afford a home loan based on the cost of the loan and household income. Some lenders provide home loans at higher debt-service ratios depending on their policies and how the loan is underwritten.

As a general rule, a DTI of six or higher is considered high.

What does an increase in the serviceability buffer mean for borrowers?

As serviceability buffers increase, some borrowers may find themselves limited in the amount of money they can borrow from a bank. APRA estimates a half a percent change in the serviceability buffer will reduce the maximum borrowing capacity for the typical borrower by around 5%.

In times of rising interest rates, some borrowers looking to refinance with another lender may no longer meet the standard serviceability buffer criteria. This can also happen following declines in house prices that reduce a borrower’s equity in their home. These borrowers are often referred to as ‘mortgage prisoners’, or people trapped in their current mortgages and unable to take advantage of better rates and terms.

What can borrowers do to meet the serviceability buffer?

Mortgage broker Rebecca Jarrett-Dalton from Sydney-based brokerage Two Red Shoes told falling outside of the serviceability buffer requirement is challenging for borrowers.

“If that happens, borrowers must then see if they can fit under the buffer criteria - or what they need to do to get under it,” she said.

“Failing this, it’s the same loan prep we do as usual: stabilise or increase income, reduce expenses and liabilities, clear up credit history or conduct.”

Ms Jarrett-Dalton said she often sees the buffer hit hardest in cases of relationship breakdowns where one party is looking to buy out their outgoing partner.

“It can be a really tough environment for new lending as a single,” she said.

Is there any flexibility in the serviceability buffer?

APRA makes limited provisions for some circumstances, saying it is important banks assess such loans on a case-by-case basis. An ‘exception to policy’ occurs when a bank approves a loan that doesn’t meet standard loan criteria, including the serviceability buffer. These are permitted under APRA’s framework on the provision they are limited and managed prudently.

In these cases, the banks may take into account other indicators of repayment capacity beyond the standard serviceability measure. This may include a borrower’s past repayment behaviour. Historically, serviceability policy exceptions have accounted for a relatively small proportion of bank’s total lending for housing. APRA puts the figure at between 2-3%.

Non-bank lenders can also exercise some discretion under the regulatory framework of ASIC. In the case of refinancing like-for-like loans, ASIC’s Responsible Lending guidelines state it may be reasonable for lenders to relax the buffer if a customer’s new financial obligations can reduce their repayments and improve their financial position. In these cases, lenders generally apply a buffer of 1%, according to Ms Jarrett-Dalton.

“This comes with strict conditions such as 12 months excellent conduct, no material increase in the loan amount or loan term (only one exception is permitted), must be for principal and interest payments, must be the same borrower, must have a high credit score, and the current repayment must be higher than the proposed repayment,” she said.

How does the lending industry feel about the serviceability buffer?

It is mandatory for all lenders to adopt prudent lending standards which include the buffer. In times of rising interest rates, there are generally calls from within the industry to reduce the buffer for new lending.

Ms Jarrett-Dalton said in the case of dollar-for dollar refinancing for borrowers seeking a better interest rate, it could be argued if a borrower can afford their loan at a higher rate, there should be no reason they couldn’t repay it at a lower rate.

However, she believes lenders are happy to adopt prudent lending standards for the benefit of everyone.

Image by Bruce Mars on Unsplash

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