If you have ever been through the process of applying for a home loan you might have been surprised by the amount that various banks and lenders were willing to lend you. As the lending market is heavily regulated ‘affordability’ needs to be defined and calculated in a consistent way, with some level of protection built in for the borrower in case circumstances change. This approach often creates a discrepancy between what customers know they can personally afford to pay and what the banks are willing to offer.
Lenders use a variety of different measures to calculate what borrowers are able to afford. These measures include the way in which they calculate income and what income can be included, the treatment of ongoing liabilities and expenses, as well as their assessment floor rates.
What is a floor rate?
An assessment floor rate, sometimes called a servicing or affordability floor rate, is an inflated interest rate used by the bank to assess your proposed loan repayments. The maximum amount of money you can borrow is determined by calculating the loan repayments based on this higher rate so that repayments do not exceed your surplus income each month once all other debts and costs have been accounted for. By using an inflated interest rate, not all surplus funds are counted towards the loan repayments. A buffer is created to protect customers by ensuring they could comfortably afford their home loan in the event of possible rate increases in the future.
In December 2014 the Australian Prudential Regulation Authority (APRA) introduced a requirement that lenders assess affordability using a minimum benchmark floor rate of 7%, although more commonly 7.25% has been used in practice. So, while borrowers’ actual repayments are based on the rate advertised by the lender, the amount of money they could borrow was decided by calculating their repayments using this 7.25% interest rate.
Following the recent reductions to the cash rate by the Reserve Bank of Australia (RBA) in June and July 2019 interest rates are at an all-time low. As a result, the calculation of affordability at a floor rate of 7.25% means repayment amounts have been assessed at double their actual level, dramatically reducing the maximum amount customers have been able to borrow.
APRA changed this guidance at the end of July 2019 to allow lenders to set their own floor rates and instead require a ‘buffer rate’ of at least 2.5% be applied to the advertised rates. The response from most lenders has been to reduce their floor rates to either;
- 5% with a buffer rate of 2.5%
- 75% with a buffer rate of 2.5%
with a handful of lenders choosing to set different floor rates ranging from 5.25% to 5.85%.
So how does this actually work?
The assessment rate that will be used to decide how much a customer can borrow will be the higher of either the advertised rate + the 2.5% buffer OR the lender’s floor rate.
- lender has a floor rate of 5.5% and an advertised rate of 3.5%.
- 5% advertised rate + 2.5% buffer rate = 6% which is higher than the floor rate
- the lender will use 6% for the affordability calculation
- lender has a floor rate of 5.5% and an advertised rate of 2.9%
- 9% advertised rate + 2.5% buffer rate = 5.4% which is lower than the floor rate
- the lender will use 5.4% for the affordability calculation
If you are interested in finding out more about your borrowing power why not contact us for a free consultation.
Michael began his career in the finance industry over 35 years ago. He progressed through the ranks at the CBA in both retail and corporate lending, culminating in a senior position as a Corporate Relationship Executive. His decision to leave the bank in 2003 to become an independent mortgage broker was driven by his desire to assist everyday customers break through the jargon of the banking world and access the best loan products in the market. His experience is wide-ranging from helping first time buyers to large commercial enterprises. What Michael doesn’t know about home loans, simply isn’t worth knowing!