How your borrowing power may be affected by the October cash rate rise.

For the sixth month in a row, we saw the official cash rate increase to 2.60% – the highest rate since reaching 2.75% in July of 2013. But what does this mean for homeowners and borrowers?

If you’re a homeowner with a variable rate or split home loan, or you’re a potential borrower, it’s time to pay attention. Not only will repayments that will be impacted by this cash rate increase, so too will your borrowing power.

Borrowing power

Borrowing power (or borrowing capacity) refers to the amount of money a lender is willing to lend you for the purchase of your chosen property. It is calculated in a variety of ways including income, assets, liabilities, debts, credit history, the value of your property and the deposit amount. How much you borrow is also up to the lender’s discretion.

Something to keep in mind is that, according to the Australian Prudential Regulation Authority, lenders are expected to apply at least a three-percentage points interest rate serviceability buffer to the current interest rate. Why, you ask? Because lenders need to ensure you will be able to repay them, while hedging against future rate rises. So effectively, this means a 2.60% interest rate increases to 5.60% with the serviceability buffer.

The impact of rising interest rates

It is inevitable that when interest rates rise, your borrowing power is likely to decrease. Before you can say “what a scam!” – it makes sense, because the repayments on your loan will increase while your income remains stagnant. Here’s a very real example of how this works.

So Melanie earns $110,000 per annum pre-tax and has no debts, no credit card, no dependents and maintains expenses of $16,500 annually – the Australian average. If Melanie takes out a loan with a 30-year term, her borrowing capacity will change depending on the interest rate. Let’s see how it changes over time.

$830,000 at 3.0% p.a.

$784,000 at 3.5% p.a.

$741,000 at 4.0% p.a.?

$702,000 at 4.5% p.a.

$666,000 at 5.0% p.a.?

$632,000 at 5.5% p.a.?

$602,000 at 6.0% p.a.

Note the drastic difference between a 3.0% interest rate and 6.0%. There is even a notable difference when the interest rate increases by 0.5%!

Now imagine if Melanie wanted to bid on a property, and hoped to take out a loan at 4.0%. If the interest rate increased to 4.5%, her borrowing power drops from $741,000 to $702,000, decreasing her bid by whopping $39,000.

How your pre-approval may be affected

Pre-approval is given when a lender believes you meet their criteria and is satisfied that lending you the specified amount is not overly risky. It is a useful process to undergo as it helps to refine your property search, and allows you to bid with confidence, knowing that you’re likely to obtain a loan for your dream home.

Pre-approvals are, however, conditional and the circumstances for granting pre-approval can change. For example, if your employment changes, or the number of dependents increases, or interest rates increase, your pre-approval could be impacted.

Though one cash rate increase is unlikely to cause much havoc with regards to your existing pre-approval, if it rises thrice during the period of your pre-approval (approximately three months), your lender may very well modify their offer to a lower amount.

So my advice in this area is to wait until you’re ready to start making offers to get your pre-approval started. If nothing becomes available until later in your pre-approval phase, have a chat to your broker to find out if anything has changed with regards to your approved borrowing capacity.

In this period of ever-increasing costs and that feeling of hopelessness that many are feeling right now, I want you to know that Kitty & Miles are here to help. We work closely with connected brokers who will find you the best loan for your needs, and who will ensure your finances are well protected during these crazy times. We’ve got this, friends!