The Reserve Bank of Australia (RBA) recently lifted its cash rate by 0.50% to 0.85%. This is the second rate rise after the RBA increased the cash rate by 0.25% last May. Because of the resilience of the Australian economy, its low unemployment rate, evidence of wage growth picking up, and high inflation at 5.1%, the RBA has started to withdraw some of the extraordinary monetary support they put in place to help Australians during the pandemic.
The outlook for economic growth in Australia still remains positive despite the ongoing uncertainties about the global economy, the lockdown in China, Russia’s invasion of Ukraine, and the oil sanctions imposed on Russia causing prices of petrol to rise above $2 a litre. The rise in the price of petrol will have a further impact on your budget.
With the cash rate rising, what changes should you expect from your home loan?
Interest rates will continue to rise. If the cash rate were to go from 0.10% to 1.25%, then expect your variable rate to increase by 1.10% (which is the difference between 1.25% and 0.10%) or more. A 1.10% rate rise equates to a $5,500 increase in your repayment per annum (or $458 per month) on a $500,000 mortgage. That’s a massive dent in your budget. Imagine if your loan is $1,000,000.
Will the rate rise affect your borrowing capacity?
Absolutely! If you are earning $100,000 a year with just a $5,000 credit card limit, expect to see your borrowing capacity fall by $68,000 from $740,000 to $672,000. A single first home buyer with an income of $75,000 annually can borrow up to $480,000 on an interest rate of 2.99% but if the rate were to rise to 4.09%, then borrowing capacity will reduce down to $437,000.
Changes in the interest buffer rate
Late last year, the Australian Prudential Regulation Authority decided that lenders should increase the buffer from 2.5% p.a. to a minimum of 3% p.a. above the loan product rate. When you apply for a loan, the lender wants to know that you will be able to repay the money owing. So when they assess your servicing capacity (how much money you have left over at the end of each month allowing you to repay the loan), they do not just calculate if you can repay the loan at the current interest rate (e.g. 2.5% p.a.), but they have been adding a buffer of 2.5% p.a. to ensure you can still service the loan in the event of future interest rate increases or other unexpected financial events.
For example, if the interest rate for the loan at the time of offer is 2.5% p.a., the lender will assess your application as though you are applying for a loan with an interest rate of 5% p.a. This is called the interest rate buffer. With a higher buffer, expect your borrowing capacity to further decrease.
What should you do before the rates start rising?
It’s great to start with a few new habits. Paying more than the required monthly repayment will put more funds into your redraw. This will help build your emergency funds. You can also start reducing your credit card debts or paying down your personal loans as quickly as you can. This will help improve your cash flow.
Your mortgage payments are likely to be the largest expense within your budget. Years of ultra-low rates have helped many Australians pay down their home loans faster. An interest rate hike will increase your mortgage repayment. Be ahead of the game by spending mindfully, managing your expenses and debts, and building an emergency fund. Have your home loan reviewed by your bank or mortgage broker to ensure that you have the most appropriate home loan for your personal situation and to help you prepare for the challenging months and years ahead.
This article is for general information only and should not be considered personal financial advice. Before making a financial decision, you should seek independent advice from a mortgage broker, financial planner, or accountant.
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