For the sixth consecutive month, the official cash rate was lifted again earlier this week – to 2.6 percent. This is the highest the rate has been since July 2013 when it was 2.75 percent.
The increase will impact any homeowner with a variable-rate or split home loan, or anyone considering taking out a new loan. However, it isn’t only repayments that will be impacted. The increasing cash rate also impacts borrowing power. But what is borrowing power and how much does an increase in cash rate and its flow-on effect to interest rates, impact it?
What is borrowing power?
Borrowing power is the amount of money a lender is willing to let you borrow to purchase property. This is also sometimes referred to as your borrowing capacity. The way it is calculated varies depending on the lender. In general, it takes into consideration your income, assets, liabilities, credit health, debts, deposit amount and the value of the property.
Lenders are also expected to apply at least a three-percentage points interest rate serviceability buffer (according to the Australian Prudential Regulation Authority’s guidelines.) This means that the lender will add at least three percentage points to the current interest rate to calculate repayments. This serves to ensure you will be able to meet the repayments, hedging against future rate rises (for example a 3 percent p.a. interest rate would be raised to 6 percent p.a. with the serviceability buffer.)
When you speak to our Debt Analysis Team, we calculate your borrowing power across the criteria of a number of lenders. This provides an idea of how much you could borrow and therefore, the top value of properties you may wish to consider within your search.
How do rising interest rates impact borrowing power?
When interest rates rise, your borrowing power is likely to decrease. This is because the repayments will increase and if your income isn’t also increasing, your ability to service that loan will drop. Let’s review how borrowing capacity can be impacted, as interest rates rise.
In this example, Nancy earns $110,000 per year pre-tax with no dependents, debts or credit card, and has the average Australian annual expenses of $16,500. For a loan term of 30 years, her borrowing capacity would change depending on the interest rate as follows:
As you can see, an increase of just half a percentage point makes a huge difference to Nancy’s borrowing power. If the lender passed on the Reserve Bank of Australia’s full increase in cash rate in its interest rates, which was by half a percentage point last month, and Nancy had been considering a loan at 4 percent p.a., the interest rate would have increased to 4.5 percent p.a. Subsequently, her borrowing power would have dropped from $741,000 to $702,000 – decreasing her potential bid by $39,000.
What if I have pre-approval?
Pre-approval is when a lender indicates they are satisfied you meet their criteria to borrow a specified amount. This is very helpful in refining your property search and bidding with confidence. However, something to keep in mind is that pre-approvals are conditional. If your circumstances change or interest rates increase, it could impact your pre-approval. While one increase in the cash rate is unlikely to void your pre-approval, if the cash rate increased three times during the period of your pre-approval (which is usually around three months) you may find the amount the lender is willing to lend you, has decreased.
Because of this, it is a good idea to get pre-approval when you are likely to start making offers rather than waiting until the end of the pre-approval period. If something has not become available until later in your pre-approval period, speak to your broker to find out if it could be impacted.
The important thing to keep in mind is that increasing interest rates do not mean doom and gloom. We have a panel of over 60 lenders and can evaluate and help find the best fit for your individual needs. There are still competitive deals available, and we can support you in optimising your borrowing power, through matching you with the right lender.
Please reach out and speak to our Debt Analysis Team if you would like to review your current loan or explore your borrowing power further.
Information contained in this document is considered to be true and correct at time of publication. In addition, the information provided is general information only, and does not take into account any individuals’ objectives, financial situation and needs. Before acting on any information contained herein, you should consider the appropriateness of the advice having regard to your personal objectives, financial situation and needs.***