The last time inflation was this high, Bob Hawke was Prime Minister. Now, three decades and eight leaders later, Australian inflation is at 7.3%, spurring the Reserve Bank of Australia (RBA) into action in an attempt to curtail the situation. In bad news for homebuyers, this means an increase in the base interest rate, which means increases in mortgage interest rates too.

So, what does this mean for borrowing capacity? Do these rising interest rates affect the amount of money Australians can borrow as part of a home loan? Unfortunately, the simple answer is – yes, they do.

Understanding borrowing capacity

What is borrowing capacity exactly? This is basically the limit of what you would be permitted to borrow when you take out a home loan or mortgage. There may be other factors that influence the amount of capital you can borrow in your specific case, but borrowing capacity – sometimes known as borrowing power – is a general indicator of how much you can expect to access.

There is no set method for calculating borrowing capacity. Instead, different mortgage providers will apply different criteria as they decide how much to offer their users. Often, this will come down to risk – the mortgage provider will want to limit their risk, and so they will factor in your income, existing debts, other expenses, and external factors.

Borrowing capacity and interest rates

Interest rates are an example of an external factor. Of course, interest rates have a big impact on your ability to repay your mortgage or home loan, simply because they influence the total cost of the loan so much. As a result, you can expect interest rates to impact your borrowing capacity too.

When mortgage providers calculate the borrowing capacity for their customers, they also need to include a margin known as a ‘serviceability buffer’. Basically, when your interest rates rise, the cost of the loan and its repayments rise too. If you were already borrowing at maximum capacity and could not afford to increase your payments at all, an interest rate rise could put you in danger of severe financial hardship. With this in mind, the serviceability buffer is designed to provide a bit of protection. Mortgage providers will calculate the maximum borrowing capacity for the customer, and then scale this back by a few percentage points to provide interest rate breathing space.

In recent years, regulations have grown tighter in this area. Mortgage providers are required to include a serviceability buffer of 3%, while before it was only 2.5%. This will automatically reduce your borrowing potential.

Indirect changes: Cost of living and borrowing capacity

Interest rate rises increase borrowing costs for everyone, not just home buyers. This means organisations such as energy companies and other businesses that serve the Australian public may find their borrowing costs have increased too.

If these companies decide to increase their prices as a way to combat rising borrowing costs, this drives up the cost of living for the public. In turn, mortgage providers will factor this into their calculations as they decide on maximum borrowing capacity.

Borrowing capacity reductions in real terms

According to research from PropTrack, the amount you are able to borrow may decrease more than you expect if interest rates go up. You might assume a 1% interest rate increase translates to a 1% decrease in borrowing capacity, and so on, but this is not the case.

PropTrack’s research suggests that borrowing capacity reduces by around 10% if interest rates rise by 1%. Meanwhile, a 2% interest rate increase will see borrowing capacity fall by 19%. All of this means that interest rates have a huge impact on the amount you would be able to borrow when you purchase a home. Across Australia, home buyers are finding that they need to recalibrate their plans and reassess their options in the face of rising interest.

Find the Mortgage or Home Loan That Suits Your Circumstances

Borrowing capacity is not a uniform value, and different mortgage providers will use different methods to calculate this. Because of these potential variations in maximum limits, it is usually worth your while to shop around in search of the best deal.

Here at Sydney Brokers, we try to make this easy for you. We help home buyers just like you to find the right mortgage and loan products for their needs. Reach out today, tell us what you need, and let’s get you where you need to be.

Disclaimer: The content of this article is general in nature and is presented for informative purposes. It is not intended to constitute tax or financial advice, whether general or personal nor is it intended to imply any recommendation or opinion about a financial product. It does not take into consideration your personal situation and may not be relevant to circumstances. Before taking any action, consider your own particular circumstances and seek professional advice. This content is protected by copyright laws and various other intellectual property laws. It is not to be modified, reproduced or republished without prior written consent.