The Australian Prudential Regulation Authority (APRA) has taken its first step in addressing the risks of ballooning debt by ordering banks to use higher interest rates when assessing mortgage applications.

The regulator said that banks need to apply a minimum interest rate buffer that is at least 3 percentage points (pps) above the loan product rate.

Previously, banks used a minimum interest rate buffer of 2.5pps.

The move is expected to reduce the maximum borrowing capacity for the typical borrower by around 5%.

The regulator expects a "fairly modest" impact of this measure on housing growth.

APRA's move was supported by the Council of Financial Regulators (CFR), which expressed concerns on the medium-term economic risks of the stronger pace of household debt compared to income.

APRA chairperson Wayne Byres said this decision to increase the minimum interest rate buffer is a "targeted and judicious" action designed to reinforce the stability of the financial system.

"In taking action, APRA is focused on ensuring the financial system remains safe, and that banks are lending to borrowers who can afford the level of debt they are taking on – both today and into the future," he said.

Mr Byres believes stronger serviceability standards are warranted to balance the risks, given that recent quarterly data showed more than a fifth of new loans approved in June were at more than six time borrowers' incomes.

“While the banking system is well capitalised and lending standards overall have held up, increases in the share of heavily indebted borrowers, and leverage in the household sector more broadly, mean that medium-term risks to financial stability are building," he said.

Why the increase in the minimum interest rate buffer?

In a statement, APRA said the most appropriate tool to enforce stricter lending rules under the current market conditions is increasing interest rate serviceability.

“It acts as a cap on leverage, is relatively easy to implement, and will not have any impact on mortgage interest rates.”

APRA said while using an interest rate floor would also be easy to implement and would not impact mortgage pricing, it would be more restrictive on owner-occupiers but would have lesser impact on investors.

"A limit on the extent of high debt-to-income borrowing would precisely target more highly indebted borrowers,” APRA said.

“Compared to raising the interest rate buffer, however, limits would be more operationally complex to deploy consistently, and may lead to higher interest rates for some borrowers as lenders effectively seek to ration credit to this cohort.”

However, it noted that this does not rule out other measures that might be used in the future.

Which borrowers will be affected?

APRA said the increase in the interest rate buffer will apply to all new borrowers.

However, the impact is likely to be larger for investors than owner-occupiers.

"This is because, on average, investors tend to borrow at higher levels of leverage and may have other existing debts," it said.

"On the other hand, first home buyers tend to be under-represented as a share of borrowers borrowing a high multiple of their income as they tend to be more constrained by the size of their deposit."

Housing Industry Association chief economist Tim Reardon said the move by APRA would only make it harder for over 50% renters who still hope to achieve homeownership. 

"First-home buyers accounted for 35% of owner occupier loans issued in August 2021 and these measures will make it harder to access a loan.

“This additional constraint is being imposed despite the share of loans with a 10% deposit or less declining since December 2020. This share is well below those observed over the past decade."

Mr Reardon said first-home buyers are typically the ones who would be hardest hit by the changes to serviceability rules. 

“Restricting access to credit for new households seeking to enter the housing market will put further downward pressure on the rate of home ownership in Australia," he said.

Photo by Louis Hansel on Unsplash.