Why banks assess loans at 8% – and why you should be grateful

We all know that interest rates are at record lows, so what better time to borrow – right?

Surely, with rates as low they are, you stand an excellent chance of being approved for a mortgage, and getting into the house of your dreams?

Unfortunately, that’s not how it works. When determining your capacity to repay a loan, the lender won’t assess your repayments at their current lowest variable rate.Instead, they use a figure known as the ‘assessment rate’ to determine how much you can afford to borrow.

The assessment rate gives you a serviceability buffer: that is, the amount you can afford to repay should interest rates rise and that rate is far higher than the 4% figure you see advertised next to the home loan.

Why do banks do this?

While banks follow this practice largely to protect themselves, it also serves to protect you too.

Their motivation is to ensure you can really, truly afford the loan. If they didn’t ‘stress test’ your loan and interest rates were to go up (and they eventually will), you could find yourself unable to afford the repayments on your mortgage and could risk losing your home. For people with multiple debts across a portfolio of properties, any increase to interest rates would have an even greater impact.

What is the assessment rate?

An industry crackdown by APRA beginning in 2014 has made it tougher for some investors to get loans, as lenders have tightened their criteria. APRA believe the serviceability buffer applied to home loans should be at least 2 per cent, but it’s often higher.

While Standard Variable Rates are determined by the cash rate set by the Reserve Bank, the assessment rate used by banks tends to be at least 2-3 percentage points higher.

Currently, most lenders use an assessment rate between 7 and 7.5% (though some lenders, like ING, currently push it to 8%), which may mean you aren’t able to borrow as much as you had hoped.

How does this affect you?

Let’s say you would like to borrow $400,000 over 30 years, and the lender is offering a variable rate of 3.9 per cent. Based on these figures, your repayments would be $1,887 per month, which you know you can easily afford.

However, by applying an assessment rate of 7.25 per cent, your repayments increase to $2,729 per month. This is the figure your bank considers when evaluating your loan, as they want to ensure you can afford your repayments on your property now and in the future.

So, in order to be approved, you’d need to be able to demonstrate you can afford the higher number each month – making it much harder to qualify for the loan.

In determining how much you can afford to repay, a lender will take into account a number of factors, including your income, other debts, and how many dependent children you have. If your serviceability doesn’t extend to cover the assessment rate, your application will most likely be knocked back.

So how can you improve your chances of being approved for a home loan?

  • Try an online calculator to see how much you could borrow, being sure to put in a rate of 7-8 per cent.
  • Clear your credit card debts and reduce the limits on them, or cancel the card entirely, as unsecured debts will reduce your borrowing power.
  • Make sure you can demonstrate your capacity to repay, through regular savings. Many lenders will also consider the rent you pay to be proof of your ability to afford a loan.
  • Work to save a bigger deposit, as this reduces the amount you need to borrow.
  • Banks currently scrutinise living expenses, mainly because of ASIC’s requirement for more responsible lending. Everything you spend reduces your borrowing capacity, including how much you spend on restaurants, cinemas, etc… If your borrowing capacity is tight, you should be reducing these for a while.
  • Most importantly, work with a broker to discuss the different types of lenders and loans, to find one that best suits your circumstances.

As mentioned earlier, ING currently assesses rates at 8%, while some other lenders use an assessment rate of 7%. This 1% variation could be the different between your loan being knocked back or approved – which is why working with an experienced broker is key to your success.