Why Your Borrowing Capacity is Falling, and What To Do About it

In August, the Reserve Bank of Australia lifted the cash rate for the fourth straight month as it attempts to curb soaring inflation. As a result, it’s now at a six-year high of 1.85%; whereas, just five months ago, it was at a historic low of 0.10%.

The cash rate determines the interest rate charged on unsecured overnight loans between lenders. Any movement up or down in the cash rate usually impacts the rates lenders charge Australians to borrow money.

So the cost of a variable-rate home loan has been pushed up by the Reserve Bank of Australia’s hikes, with the most recent 0.50 percentage point increase adding $281 a month in repayments for a borrower with a $1 million mortgage, according to RateCity, assuming the lender passes on the cash rate hike in full.

That’s on top of the $663 this borrower has already had to find for the cumulative impact of the May through to July increases.

But rising interest rates don’t just make mortgages more expensive – they also reduce your borrowing power.

What’s borrowing power?

Your borrowing power (or borrowing capacity) is the maximum amount of money a lender will let you borrow for a mortgage.

While each lender has its own in-house method for calculating borrowing power, the lender will look at things like your expenses, income, debts and lifestyle to work out how much money you can afford to pay back each month, without falling into financial difficulty.

The higher the interest rate, the higher the cost of borrowing and the more expensive the monthly repayments. So, all other things being equal, the amount of money you can borrow naturally falls when rates rise.

Stricter lending regulations

Then there’s the ‘serviceability buffer’. This is a safety net that all lenders have to factor into their borrowing capacity assessment to check whether you could still afford to repay your loan if interest rates were to rise.

In October 2021, the minimum serviceability buffer was increased from 2.50 to 3.00 percentage points by APRA, the financial services regulator.

That means, for example, if you were to apply for a home loan with a variable rate of 3.75%, you would actually be assessed on your ability to pay an interest rate of at least 6.75%.

What’s the impact?

You can quickly see how rising interest rates can impact your borrowing power. But by how much will your maximum borrowing size go down?

While everyone’s situation is different, a PropTrack analysis found an interest rate increase of 1 percentage point could lower a household’s borrowing capacity by 10%, based on a $1 million mortgage.

Your maximum borrowing size could drop by 19% if rates rose by 2 percentage points.

Rising expenses also reduce borrowing power

It’s not just higher interest rates that are reducing your borrowing capacity; you also need to factor in the rising cost of living.

When groceries, fuel, utilities and other regular bills get more expensive, this puts a squeeze on your monthly budget, impacting how much you can afford to repay on a loan. It also makes it harder for first home buyers to save a deposit.