With interest rates now reaching their peak – should APRA reduce the serviceability buffer?

March 21, 2023

The serviceability buffer is a key regulatory setting that impacts how much Australians can borrow, and therefore what happens to home prices.

In late February, APRA left the buffer unchanged at 3 percentage points (ppt).

But many – particularly lenders – have called for it to be reduced.

It’s worth looking at the data to understand what that would mean for borrower resilience. Because it matters: a 0.5ppt decrease increases borrowing capacities by around 5%

The serviceability buffer ensures financial resilience from interest rate increases

The serviceability buffer is the amount lenders add to current mortgage rates before assessing how much to lend a borrower.

Currently, new owner occupiers facing interest rates of around 5.5% must be able to afford to repay a loan if interest rates increased to 8.5%.

The serviceability buffer is designed to insulate borrowers from interest rate risk. If interest rates go up, borrowers should be able to afford to repay the loan as long as the increase is less than the buffer.

If there were no buffer, any interest rate increase would push anyone who borrowed the maximum offered into a position where they could no longer afford to make repayments.

But it is worth remembering that very few borrowers borrow their maximum – around 10% according to CBA – so most have even more resilience than described simply by the minimum buffers.

1c

A simple change by APRA could ease some of the pain of rising rates – but is it worth it? Picture: Getty

The buffer and other serviceability settings have been tweaked extensively

A rough recent history of the buffer and related measures is:

  • December 2014: APRA standardised serviceability assessments to require a minimum 2 ppt buffer and 7% floor (a minimum serviceability rate regardless of the current interest rate)
  • July 2019: the floor was removed, and the buffer increased to 2.5ppt
  • November 2021: the buffer increased to 3 ppt
2c

Over much of the past decade, the 7% floor rate was binding, meaning interest rate changes did not change borrowing capacities.

But with interest rates persistently below that level: “the gap between the 7 per cent floor and actual rates paid has become quite wide in some cases – possibly unnecessarily so” according to APRA.

In other words, the amount of resilience built into mortgages was too large and imposed a large cost in terms of restricting borrowing and locking people out of the housing market.

The current buffer covers around 95% of historical interest rate increases

The buffer protects against interest rate risk, or interest rates increasing after a borrower has taken out a loan.

No buffer can eliminate all interest rate risk since interest rates can increase indefinitely.

But the first 5 or 7 years of a loan are when borrowers are most susceptible to interest rate increases. This is because after this point they have generally seen their income and equity increase enough to significantly reduce the burden of mortgage repayments.

3c

It is rare for borrowers to face mortgage rates 3ppts above their initial rate. Such increases have only occurred for loans taken out from 2001 to 2003 (when it almost only affected loans more than 5 years old) and – very saliently – for loans taken out in 2021.

Quantifying this interest rate risk, 95% of interest rate increases over the first 7 years of a loans life were less than 3.05ppt. This covers the last 30 years, since the RBA has been targeting inflation with interest rates.

This is almost exactly the current level of the buffer: 3ppt.

Alternatively, if you were only concerned with risks over the first 5 years of mortgages, 95% of increases are less than 2.92ppt. Not too dissimilar.

Higher interest rates over the remainder of 2023 will shift these distributions up slightly. But 3ppt seems about right to insulate borrowers from around 95% of historical interest rate risk.

Lowering the buffer to 2.5ppt – its level before late 2021 – would cover only around 80% of historical interest rate increases for borrowers over the first 7 years, and 90% over the first 5 years.

Before making any change to the buffer, APRA will need to decide if this level of resilience is sufficient.

It would be impractical to adjust the buffer based on expected interest rates

It seems intuitive that since interest rates have increased sharply, the buffer does not need to be as large now. Alternatively, it is less likely rates will increase another 3ppt from now so the buffer can be reduced.

Similarly, when rates were low they were more likely to ‘normalise’ or increase. This was, broadly speaking, the motivation behind the minimum serviceability rate or floor of 7% which prevailed before 2019.

These ideas suggest the buffer should change based on the current level of interest rates. However, operationalizing this is practically difficult.

APRA would require accurate forecasts of interest rates. But financial markets have been shown to have large forecasting errors.

4c

And the reintroduction of a floor rate would require APRA to have a view on the ‘normal’ level of mortgage rates – something considered extremely difficult to tie down, and which estimates suggest have changed markedly over the past. In practice, lenders continue to use floor rates, so APRA would need to have strong evidence that these are not being set high enough.

5c

Buffer settings could not change as quickly as interest rate forecasts, which often adjust substantially over a short period of time. And perhaps more importantly, if these forecasts are wrong, borrowers may be left with reduced resilience.

These are the arguments for a well analytically defined buffer that is constant throughout the economic cycle.

The buffer cannot account for inflation or income loss

APRA has stated that serviceability should account for more than just interest rate risk: “The buffer provides an important contingency not only for rises in interest rates over the life of the loan, but also for any unforeseen changes in a borrower’s income or expenses”.

In practice any spare cashflow, such as that provided by the buffer, can protect against these shocks, but the buffer cannot be calibrated to account for these risks.

No loan is written to withstand significant income falls, such as job loss, and nor should it: the result would be no lending at all.

And incorporating inflation into the calculation of the buffer would lead to smaller not larger buffers – since income growth exceeds expenses inflation most of the time (although current conditions are a clear counter-example).

It remains to be seen if the buffer will be reduced

APRA will need to judge if reducing the buffer to 2.5ppt – and enabling 5% higher borrowing capacities – is worth reducing the resilience of future borrowers from 95% of historical interest rate risk to 80-90%.

However, adjusting the buffer based on expected interest rate movements is likely to be difficult in practice and would require an ongoing discussion, and adjustment of the right serviceability settings. But such settings are not designed to be changed quickly – for one it would add uncertainty for lenders and borrowers throughout the purchasing journey.

It also places a lot of pressure on getting interest rate forecasts right, so borrowers aren’t left with insufficient buffers right when they need it most.

 

Source: Realestate.com.au

You might be also interested in

December 2024 House Price Report
Home prices across the combined capitals continued to climb over the final quarter of 2024, marking the eighth consecutive quarter of growth for houses and the seventh for units, with
VIEW POST
12a300fc Cbb1 1183 C044 152bf2574ba2
Victoria loses 20,000 rental properties in 18 months
Victoria shed 20,000 properties from the state’s rental stock over 18 months as higher interest rates, extra costs due to new minimum rental standards and higher taxes on property investors
VIEW POST
5c649542 Cafb 4ef0 00d5 Ea5cbfaa7a0d
Victoria’s stamp duty changes: What buyers need to know
Beginning in October, stamp duty has been significantly reduced for all off-the-plan apartments, units and townhouses in Victoria. This Victorian government initiative aims to spur development in a bid to
VIEW POST
578c6948 0f59 B3d4 8e46 Fc5725498f6a
Rents reach record high but price growth halts in most capitals
Australia’s national median rent price has crept to a new high, but an uptick in the number of available rentals has kept rents steady across much of the country. Rents
VIEW POST
F275ae36 A47d 91db 0012 9803ac9ca1a5
’Year of the first homebuyer’: 5 ways to get into the market
Easing house prices, government incentives, and a predicted interest rate cut have got experts claiming 2025 could be the year of the first homebuyer. Ray White chief economist Nerida Conisbee
VIEW POST
354021232 978827216900921 2322611816567184398 N
Neighbourhood Guide – Brunswick
Brunswick, Victoria, is a suburb that pulses with energy, creativity, and cultural diversity. Known for its eclectic blend of art, music, and cuisine, this vibrant locale has transformed into one
VIEW POST
Gettyimages 930003072
The best time of year to nab a rental according to the property data
If you’re looking for a new rental, one month of the year may give you the best chance of snagging the perfect place. Gearing up to find a new rental? You
VIEW POST
Capi 01d52420af55f78551b8f9fd0f3079c6 19e4997167d732fe8a6d0e502e93cceb
Revealed: Big bank insider predictions for 2025
Denton Pugh believes the property dream is not over for thousands of Aussies looking to get into the market. A key executive at one of Australia’s top four banks –
VIEW POST
03 Mcr Ivanhoe Grammar School John Gollings
Neighbourhood Guide – Ivanhoe
Ivanhoe, Victoria, is a picturesque suburb celebrated for its blend of natural beauty, rich heritage, and a vibrant community spirit. Known for its historic architecture and leafy streets, Ivanhoe boasts
VIEW POST
Capi 720fc7cc60b07ca4775bfc50c3fbc924 19fd23c6f002eb7ea2e94b6bff754b85
What needs to happen for interest rate cuts to come sooner than we think
Public spending is continuing to be a thorn in the Reserve Bank of Australia’s side as it looks to determine its timeline toward interest rate cuts, the governor has said.
VIEW POST

Get your Free Property Guide.

Here goes your text ... Select any part of your text to access the formatting toolbar.

Get your free Sales Report for With interest rates now reaching their peak – should APRA reduce the serviceability buffer?

Get your free Sales Report for With interest rates now reaching their peak – should APRA reduce the serviceability buffer?

Subscribe to hear the latest

Start The Conversation Today.

Call us on:

1300 850 730

Request a Callback:

Send us a Message:

Privacy Policy

Get your Free Property Guide

Get your free Suburb Report for With interest rates now reaching their peak – should APRA reduce the serviceability buffer?

Get your Free PDF copy of Make Money Simple Again

Privacy Policy

Who we are

Suggested text: Our website address is: https://motionproperty.com.au.

Comments

Suggested text: When visitors leave comments on the site we collect the data shown in the comments form, and also the visitor’s IP address and browser user agent string to help spam detection.

An anonymized string created from your email address (also called a hash) may be provided to the Gravatar service to see if you are using it. The Gravatar service privacy policy is available here: https://automattic.com/privacy/. After approval of your comment, your profile picture is visible to the public in the context of your comment.

Media

Suggested text: If you upload images to the website, you should avoid uploading images with embedded location data (EXIF GPS) included. Visitors to the website can download and extract any location data from images on the website.

Cookies

Suggested text: If you leave a comment on our site you may opt-in to saving your name, email address and website in cookies. These are for your convenience so that you do not have to fill in your details again when you leave another comment. These cookies will last for one year.

If you visit our login page, we will set a temporary cookie to determine if your browser accepts cookies. This cookie contains no personal data and is discarded when you close your browser.

When you log in, we will also set up several cookies to save your login information and your screen display choices. Login cookies last for two days, and screen options cookies last for a year. If you select “Remember Me”, your login will persist for two weeks. If you log out of your account, the login cookies will be removed.

If you edit or publish an article, an additional cookie will be saved in your browser. This cookie includes no personal data and simply indicates the post ID of the article you just edited. It expires after 1 day.

Embedded content from other websites

Suggested text: Articles on this site may include embedded content (e.g. videos, images, articles, etc.). Embedded content from other websites behaves in the exact same way as if the visitor has visited the other website.

These websites may collect data about you, use cookies, embed additional third-party tracking, and monitor your interaction with that embedded content, including tracking your interaction with the embedded content if you have an account and are logged in to that website.

Who we share your data with

Suggested text: If you request a password reset, your IP address will be included in the reset email.

How long we retain your data

Suggested text: If you leave a comment, the comment and its metadata are retained indefinitely. This is so we can recognize and approve any follow-up comments automatically instead of holding them in a moderation queue.

For users that register on our website (if any), we also store the personal information they provide in their user profile. All users can see, edit, or delete their personal information at any time (except they cannot change their username). Website administrators can also see and edit that information.

What rights you have over your data

Suggested text: If you have an account on this site, or have left comments, you can request to receive an exported file of the personal data we hold about you, including any data you have provided to us. You can also request that we erase any personal data we hold about you. This does not include any data we are obliged to keep for administrative, legal, or security purposes.

Where your data is sent

Suggested text: Visitor comments may be checked through an automated spam detection service.