Important changes to your borrowing capacity

Borrowing capacity has probably never been tighter in the 20 years since I started ProSolution!

This is delaying investment plans for some clients.

However, I expect this to be temporary and an easing in borrowing capacity might not be too far away.

How borrowing capacity rules have changed over recent years

In 2019, the banking regulator, APRA told banks to include a ‘serviceability buffer’ of at least 2.5% above the actual interest rate to test borrowing capacity.

In October 2021, it increased this to a minimum of 3%, when actual interest rates were circa 2% p.a.

Therefore, if you are applying for a home loan today, your repayments will be tested at a rate of around 7.55% p.a. P&I over 30 years.

Interest-only investment loan applications are tested at an interest rate of circa 8.35% p.a. on a P&I basis over 25 years.

This means benchmark repayments for a $1 million home loan would be $84k p.a. (compared to $61k p.a. for actual repayments), and almost $95k p.a. for an interest-only investment loan (compared to $54k p.a. for actual repayments).

Therefore, benchmark repayments are now over 80% higher than actual repayments for interest-only investment loans.

To give you some context, benchmark interest rates over the past 20 years have typically ranged between 6% and 7% p.a.

It is probably unnecessary for benchmark interest rates to exceed circa 7% p.a. on a permanent basis.

Rising interest rates reduce your borrowing capacity

The issue is that the RBA has hiked rates so quickly i.e., 2.50% over the past 6 months and the banking regulator hasn’t adjusted its benchmark interest rate guidance accordingly.

The 3% p.a. buffer was prudent when the cash rate was only 0.10% p.a. but arguably excessive now.

For example, a borrower needs to demonstrate they have over $62,000 of surplus income to qualify for a $1 million investment loan to buy an investment property:

• Rental income @ 3% of property’s value shaded by 70% to allow for expenses = $20,000
• Less P&I repayments on $1m @ 8.35% over 25 years = $95,450
• Add back negative gearing tax benefit = $13,000
• Cash surplus required = $62,450 (which equates to an income surplus of $100k p.a. before tax)

The RBA would like to see lending volumes fall

It is noteworthy that new home loan volumes have been unsustainably high over the past two years, as illustrated in the chart below.

New investment home loan volumes have been above average too, but not to the same extent as home loans.

This increase in volume was no doubt stimulated by very low-interest rates.

Now that interest rates have increased, I anticipate volumes will contract and eventually return to normal levels.

No changes are expected until next year

However, I don’t think the banking regulator will make any changes to serviceability benchmark interest rates until new home loan volumes normalise i.e., home loan volumes reduce to between the two blue horizontal lines in the above chart.

I expect that will happen this year and therefore leave room for the regulator to normalise benchmark interest rates sometime next year.

I suspect the RBA would be rather pleased that house prices have been cooling over the past 6 to 8 months, as it doesn’t want asset prices to become overheated.

Changing the benchmark interest rate too early might restimulate demand for borrowing, which is why I don’t think the regulator (APRA) will make changes until next year.

How you can maximise your borrowing capacity

In the meantime, there may be some things you can do to maximise your borrowing capacity, including:

• Borrow money before you change jobs (employers), especially if you receive variable remuneration (e.g., bonus/commission), as a lender will not rely on this income unless you have 2 to 3 years of history of receiving it.
• Minimise credit card limits. Banks will include 3-4% of your card credit limits as a monthly expense which reduces your borrowing capacity. In recent years, I have switched to using one charge card (instead of several credit cards) mainly to reduce bank fees and maximise points but also to maximise my borrowing capacity.
• Delay taking out any new car leases/finance until after you have made changes to your mortgages, as short-term loan repayments (e.g., car leases) tend to be relatively high compared to the liability amount.

• Protect your credit score, as discussed here.
• If you have Higher Education Loan Program (HELP) debt, consider repaying it, as repayments can be as high as 10% p.a. which really eats into your borrowing capacity, particularly for first-home buyers.
• Minimising living expenses 3+ months prior to lodging an application will demonstrate what level of discretionary income you have, which you will be able to contribute towards meeting loan repayments if required.
• If your children go to a private school, the bank will include school fees in addition to living expenses when calculating your borrowing capacity. Some schools offer attractive discounts for prepaying school fees which also has the added advantage of increasing your borrowing capacity. If your children are in year 8 or later, some banks will exclude private school fees.

Investing plans may be on hold

Some of my clients are in a holding pattern. I have recommended that they invest in investment-grade property but at this stage, they don’t have sufficient borrowing capacities to do so, despite having a very strong surplus cash flow and asset position.

In this situation, we have two options.

We could adjust the strategy and invest in a lower-value property, which might include compromising on asset quality.

Alternatively, we can wait a few months to see if the borrowing capacity loosens up, which I have advised them to do.

Building wealth is a marathon, not a sprint.

Sometimes the most intelligent thing to do is wait and do nothing.

It’s tempting to react and do something, but that is often the wrong approach.

Patience is a necessary attribute for all successful investors.

About Stuart Wemyss Stuart was a Chartered Accountant before establishing mortgage broking firm ProSolution Private Clients. He has authored two books and shares his experience with readers of Property Update. Visit www.prosolution.com.au