How Does an Interest Rate Rise Affect Your Borrowing Capacity?

When interest rates rise, most people immediately think about higher home loan repayments. But a rate rise can also affect how much a lender is prepared to let you borrow.

This matters if you are planning to buy a property, have an existing pre-approval or are making offers based on an earlier borrowing-capacity estimate.

Understanding the connection between an interest rate rise and borrowing capacity can help you set a realistic property budget.

Why can borrowing capacity fall when interest rates rise?

When a lender assesses your application, they do not simply check whether you can afford the advertised home loan rate.

They calculate your repayments using a higher assessment rate. This helps the lender determine whether you could continue meeting your repayments if rates increased or your circumstances changed.

When home loan rates rise, the assessment rate used by lenders will generally rise as well. The higher assessed repayment leaves less room in your budget, which can reduce your maximum loan amount.

Your income may not have changed, but the lender’s calculation of what you can comfortably afford may have.

A simple borrowing-capacity example

Consider a buyer who has already had their borrowing capacity assessed.

Their income, debts and expenses have not changed, but interest rates rise before they find a property. When the lender updates its servicing calculator, the buyer’s maximum loan amount may be lower because the lender is now testing their ability to repay the loan at a higher rate.

There is no standard reduction that applies to everyone. The effect will depend on the proposed loan amount, income, expenses, existing debts, dependants and the lender’s individual servicing calculations.

This is why an assessment completed several months ago may no longer accurately reflect what a lender will approve today.

Does every lender calculate borrowing capacity the same way?

No. Although lenders follow responsible-lending requirements, their calculators and credit policies can produce different results.

Differences can include how a lender treats:

• Overtime, allowances and bonuses

• Casual or contract income

• Self-employed income

• Rental income

• Credit-card limits

• Personal loans and other debts

• Dependants and living expenses

• Existing investment-property commitments

One lender may also accept an income source that another lender will not use at all.

This is why the lender with the lowest advertised interest rate is not necessarily the lender that will provide the borrowing capacity you need.

Can a rate rise affect an existing pre-approval?

It can.

A pre-approval is generally conditional and valid for a limited period. If interest rates change, your pre-approval expires or your financial position changes, the lender may reassess your application using its current policies and servicing calculator.

A pre-approval is also not the same as unconditional approval. The lender will still need to assess the property and confirm that all conditions have been met.

If you received your pre-approval before a recent rate rise, it is worth having the figures checked before signing a contract or increasing your offer.

What can you do if your borrowing capacity has fallen?

Depending on your circumstances, there may be several options.

Reduce or close unused credit-card limits

Lenders assess the credit limit, not just the amount owing. Even a credit card with a zero balance can reduce your borrowing capacity.

Repay personal loans or other debts

The required monthly repayment on a personal loan can have a significant effect on servicing. Paying out a debt may increase your borrowing capacity, although you also need to consider the effect this will have on your available deposit.

Adjust your property budget

A slightly lower purchase price may provide more breathing room for repayments, purchasing costs and unexpected expenses.

Increase your contribution

A larger deposit reduces the amount you need to borrow. However, it is important to allow for stamp duty, legal fees and other purchasing costs rather than putting every available dollar into the deposit.

Compare lender policies

Different lenders may reach different results using the same financial information. The right lender will depend on your overall circumstances, not just the interest rate.

Should you wait for rates to fall before buying?

Not necessarily.

Interest rates are only one part of the decision. Property prices, your deposit, income, existing debts and personal plans also need to be considered.

Rather than trying to predict exactly what rates or property prices will do, start by getting an up-to-date assessment. This will give you a realistic budget based on current lender calculations.

Check your figures before making an offer

If it has been a few months since your borrowing capacity was assessed, or interest rates have changed since you received pre-approval, it is a good idea to review your position.

I can compare different lenders, explain how they are likely to assess your circumstances and help you establish a comfortable property budget before you make an offer.

My Mortgage Hacks is based in Brisbane and assists clients across Queensland and Australia.

Get in touch if you would like your borrowing capacity reviewed.

This article contains general information only and does not take into account your personal objectives or financial situation. Lending criteria, interest rates and borrowing-capacity calculations vary between lenders and may change.