Rate rises could reduce the amount you can borrow on a home loan by 20%

While the impact of rising interest rates on existing borrowers is well publicised, those purchasing a home will also be forced to make adjustments, namely settling for a smaller loan.

In a recent speech, Reserve Bank head of domestic markets Jonathan Kearns said this year’s rate hikes have already decreased the amount of debt prospective borrowers can take on by as much as one fifth.

“Given this 225 basis point increase in the cash rate has been fully passed through to mortgage interest rates, it will have reduced borrowers' maximum loan size by around 20 per cent,” he said.

This comes almost a year after APRA introduced stricter guidelines around serviceability buffers, which are used by banks when assessing borrowers’ ability to continue paying their loan at a higher rate.

Previously, banks were required to apply an interest rate buffer of at least 2.5 percentage points to their loan product rates. This was lifted to 3.0 percentage points to ensure stability in the financial system and as a contingency for future rate rises.

At the time, the change lowered the maximum loan size a borrower could take out by up to 5 per cent, a difference which Kearns points out has been dwarfed by the current round of rate hikes.

“The increase in the cash rate since May has been 225 basis points, and so this has had a much larger impact on maximum loan size than APRA's requirement.”

“And because the assessment rate also applies to any existing debt, the decrease in borrowing capacity is even larger for prospective borrowers who have existing debt, such as property investors.”

Fortunately, it’s uncommon for borrowers to take out the maximum amount a bank is willing to lend them, with banks reporting that these customers only make up around 10 per cent of their loan books.

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“As a result, even if all borrowers' maximum loan size is reduced by 20 per cent in response to higher interest rates, not all new borrowers will have to take out a loan that is 20 per cent smaller,” said Kearns.

“For many borrowers, the amount they spend on a new home would decline only slightly or not at all (including because their savings to be used as a deposit need not decline with higher interest rates).”

However, Kearns points out that the rapid lift in interest rates, which is set to continue until the RBA can bring inflation within target, also means new borrowers will be making larger repayments on their loans. 

“For example, with the 225 basis point increase in the mortgage interest rate – from average mortgage rates prior to May – monthly payments on a new (principal and interest 25-year) loan will be around 25 per cent larger,” he said.

“This increase in mortgage payments can influence how much people want to borrow.”

Importantly, this won’t necessarily apply to existing borrowers, many of whom are paying above the minimum repayment amount set by their lenders or making regular contributions to their offset accounts.

Fixed rate loans also make up a significant portion of the residential mortgage market — currently around 35 per cent — and these borrowers won’t face an increase in repayments until their fixed terms expire.

For information on interest rates and lending trends, head over to our home loan statistics page. And if you’re in the market for a home loan, visit our home loan comparison page, or browse the selection below.