If you’re planning to or have already applied for a home loan, you’ll probably know that lenders assess your borrowing power before your home loan application gets approved.
Most first home buyers mistakenly think lenders refer to the current standard variable rate when evaluating a buyer’s borrowing capacity. However, lenders consider an assessment rate to understand how much you can borrow.
This article clears the way for a better understanding of assessment rates and how they influence your capacity to take out a home loan.
What is an Assessment Rate?
All lenders have a standard variable rate which they apply to their variable rate home loan products.
During the life of a home loan, interest rates fluctuate based on the existing environment. Therefore, when you apply for a loan, your lender will assess your financial situation at a higher rate, known as the assessment rate.
A higher assessment rate offers lenders a greater sense of security in the prospective home loan borrowers’ capacity for monthly repayments. In addition, it’s a step towards minimising risk against sudden future interest rate increases.
Essentially, your lender’s home loan assessment rates can impact your capacity to borrow.
Who Determines a Lender’s Assessment Rate?
Lenders use their own standard variable rate (SVR). This rate is calculated using the cash rate of the Reserve Bank of Australia (RBA).
They will generally add around 3.0 percentage points to RBA’s cash rate further to arrive at their SVR. This helps lenders cover the funding costs of the loan, as well as earn a profit margin.
When assessing your home loan application or serviceability, your bank typically adds about 3% above the bank’s SVR. Lenders use different mortgage assessment rates for their other loan products.
For example, if you apply for a home loan with an interest rate of 4% p.a., your bank may use a higher floor rate, i.e., 7% p.a., to assess your ability to make your mortgage repayments in case interest rates increase.
Where to Find My Lender’s Assessment Rate?
Assessment rates vary across different lenders. However, lenders generally don’t publicise their assessment rates. As a result, many applicants are unaware of the assessment rates before lodging their home loan application, and some fail the serviceability test.
It’s therefore essential for you to know that your lender or broker must disclose the assessment rate and the sensitised repayments at that rate in the credit proposal given to you.
The Credit Proposal document lists your objectives & specific need for the loan and the rates/fees applicable against your loan. This document has to be sent to you by your broker or lender ahead of you submitting your loan application.
Why is an Assessment Rate Important for Home Loans?
If you’re on a variable rate home loan, any increase in RBAs rate will consequently lead to a rise in the standard variable rate. This implies that your monthly interest payments will increase too.
The assessment rate is, therefore, like a litmus test for your capability to make your home loan repayments. If your income cannot provide for this extra interest, your lender may not consider it a profitable, robust home loan application, and you won’t qualify for a home loan.
In many ways, you can confidently take on a loan based on the knowledge that you won’t fall back on your repayments should circumstances change.
APRA’s role in assessment rates and the implications on your home loan
The Australian Prudential Regulatory Authority (APRA) has played a crucial role in ensuring the financial system’s safety. As a result, banks lend to borrowers who can afford the debt they are taking on – presently and in the future.
In October 2021, in a notification to authorised deposit-taking institutions (ADIs), APRA informed lenders that they are expected to assess new borrowers’ capability to meet loan repayments at an interest rate that is a minimum 3.0 percentage points above the loan product rate. This is compared to the buffer of 2.5 percentage points that ADIs used earlier.
The increase in interest rate buffer applies to all new borrowers. However, the impact of the higher serviceability buffer is more likely to be more significant for property investors as compared to owner-occupiers.
This is mainly because, on average, investors often tend to borrow at higher leverage levels. In addition, they may have other debts to which the buffer would be applied.
In contrast, first home buyers are observed to be more constrained by the size of their deposit.
While APRA’s mandate is directed at ADIs, several smaller lenders don’t use assessment rates. Instead, these lenders use their standard variable rates when assessing borrowing power. Therefore, home loan aspirants may have a better shot of being approved for a loan if they approach small lenders.
How Does an Assessment Rate Affect My Borrowing Capacity?
Consider a scenario where a first home buyer looks at borrowing $450,000 with a bank for a 30-year term. The difference in weekly repayments would be as follows:
- Repayments at discounted, actual interest rate of 3.90% – $489 per week
- Repayments at the SVR of 5.50% – $589 per week
- Repayments at the assessment rate of 7.50% – $725 per week
To qualify for a loan, the home buyer should be able to afford a potential repayment of $725 per week. If not, downsizing the loan amount may help improve the monthly repayment and borrowing capacity.
According to APRA, excluding the impact from other aspects of serviceability assessment, the increase of 50 basis points in the serviceability buffer in Oct 2021 will decrease the borrower’s maximum borrowing capacity by around 5%.
In a nutshell, the buffer rate does limit your borrowing capacity when you’re taking the opportunity for credit to the outer edge of your capacity.
How to Work Out Borrowing Power
According to Graeme John, Head of Growth at Joust, “Along with the assessment rate, lenders also apply their internal criteria when assessing your borrowing power. For example, how your lender views your credit card and other debt, the amount they allow for minimum living expenses, and the percentage of rental or other income they’ll consider for repayment servicing. These factors can also affect your borrowing power.”
Most lenders generally use the following formula to calculate your borrowing capacity:
Gross Income - (tax - living expenses - current financial commitments - new financial commitments - buffer) = Your Monthly Surplus
If you’re planning to apply for a home loan, you can read through how lenders calculate your borrowing capacity. That way, you can be in control of your home loan search and obtain a loan with a suitable rate.
Pros of Assessment Rates
- A responsible lender: By using the assessment rate, credit licensees ensure that they enter into a suitable credit contract for the borrower.
- Capability to make repayments: The assessment rate especially ensures that first home buyers can still afford to make repayments if interest rates rise.
- Confidence: Home buyers feel more confident when taking a loan, knowing they can afford repayments without significant lifestyle alterations.
- Limits impact on the economy: Using the assessment rate to ensure the buyer’s repayment capacity eventually limits the economic effects caused due to defaulting on repayments.
Cons of Assessment Rates
- Lower borrowing power: You may have to scale down your borrowing amount to match the assessment rates.
- Interest rate fluctuations: Interest rates have been rising post-covid. So, assessment rates will increase accordingly. In such a situation, home buyers, especially first home buyers, may find it challenging to qualify for a home loan.
Use Joust for Competitive Home Loan Rates
If you’re looking for a suitable home loan and worried about the assessment rate challenges, you could set up a live auction on Joust in just three minutes.
Instead of scouting for lenders, now have the banks and lenders bid for your home loan. You can choose a home loan from genuine offers and lower interest rates on a secure platform, with no obligation to proceed.