When you apply for a home loan, the bank or lender you are applying with will make a risk assessment about your ability to pay off the home loan. They will take into account your income, average expenses, debts and assets, among other things.

To protect themselves, the lender will also want to make sure you would continue to be able to repay your loan if circumstances changed at some point during the loan term. Interest rates may go up, for example, or there could be some substantial change to your income or living expenses. To test this, the lender adds a 'serviceability buffer' to your interest rate when assessing your home loan application.

For example, if you are applying for a home loan at 5% p.a, the lender might impose an additional serviceability buffer of 3%. This means that you will need to prove to the lender that you are capable of repaying your loan at an 8% p.a. interest rate.

Alternatively, lenders may have a minimum floor rate that applications must be tested against. For example, if the floor rate was 6% p.a., then applicants are assessed on their ability to repay their loan at a 6% interest rate, even if the product rate is lower.

Many providers will have both a serviceability buffer and a floor rate, with applications assessed against the higher of the two.

Who chooses the serviceability buffer?

The minimum serviceability buffer is recommended by the Australian Prudential Regulation Authority (APRA). The most recent update to its guidelines was October 2021, when it announced that it now expects ADIs - banks - to assess new borrowers' capacities to meet their loan repayment obligations at an interest rate at least 3 percentage points above the loan product rate. Previously, this figure was 2.5%.

This was a measure designed to mitigate 'medium term risks to financial stability'. In 2022 the cash rate increased by 300 basis points in a clear demonstration of why serviceability buffers are important. Those who began their variable rate home loans in 2021 are now likely to be paying an interest rate at least 3 percentage points higher.

These guidelines do not apply to non ADI lenders though - non-banks fall under supervision from another regulator, the Australian Securities and Investments Commission, or ASIC. Still, the buffer rate is usually similar - currently 2.5%.

Is the serviceability buffer different to the debt service ratio?

A serviceability buffer is an additional loading of a certain percentage point amount in interest rates. The debt service ratio meanwhile, is a different tool lenders may use to assess a home loan application. The debt service ratio refers to the percentage of an applicant's income that will need to go towards paying off their home loan.

A debt to service (or debt to income, DTI) ratio is commonly expressed as a multiple of income. For example, if a borrower is on a $100,000 income, and their home loan size is $600,000, that's 6x. Anything more than 6x is considered by APRA to be highly leveraged, or riskier.

Many banks and lenders have stopped lending for DTI ratios about 7x, and it could be hard to get a home loan if the amount you want to borrow is 6x or above.

Mortgage stress - what is it?

The debt to income ratio can also be calculated by dividing the proposed monthly mortgage payments for an applicant by their monthly income, and expressed as a percentage.

Many lenders use the 30% threshold as a benchmark for mortgage stress. If the repayments for a loan are going to work out to be more than 30% of the applicant's monthly income, the lender may be more apprehensive about approving the loan.

However there's a lot more than goes into the approval process than just income and ratios - lenders will also use the Household Expenditure Measure, or HEM.

What are the benefits of serviceability buffers and floors?

1. Help to prevent mortgage stress

The primary function of serviceability buffers and floors is to ensure that banks and other lending institutions are only giving out loans to people who can comfortably pay them back. Interest rates are often subject to dramatic market changes, so having serviceability buffers to account for substantial change to the spending power of the home loan applicant helps limit the amount of people who suddenly find themselves unable to keep up with their repayments.

2. Stability in the housing market

Serviceability buffers mean less risky home loans are given out by lenders, and so act as a stabilising mechanism to the housing market. Famously, the collapse of the US housing market was the primary driver of the 2008 Global Financial Crisis, as home loan holders began to default in droves after a sustained period of banks handing out high risk loans. The same depth of financial collapse was not seen in Australia.

3. Prevent banks reducing their loan standards and undercutting one another

It's easy to think about 'the banks' as a single giant entity and forgot that the financial services industry, like any other, consists of various companies in competition with each other. Every loan written by a bank is essentially a product sold, so they are naturally trying to give out as many loans as possible.

While banks want to avoid defaulted loans, without serviceability buffers imposed by APRA, they could undercut each other in their approval standards, writing riskier loans to keep business booming.

What are the criticisms of serviceability buffers?

1. Reduces borrowing capacity

Naturally, serviceability buffers also mean that the amount applicants can borrow is reduced. APRA estimated that the 50 basis point increase introduced in October 2021 would mean an average decrease of 5% of applicants' borrowing power. Higher-income households are less affected by higher debt ratios as factors like core living expenses generally remain the same across different incomes.

2. Potential to be overly cautious

The serviceability buffer is designed to account for pessimistic visions of the future, whether from increased interest rates or reduced income for the loan holder. While this is the best way for the bank or lending institute to protect themselves from the risk of the borrower defaulting, it also creates many situations where applicants are rejected for a loan that they could have paid off without the serviceability buffer, only for interest rates to go down.

However as seen in 2022, interest rates increasing by more than the serviceability buffer can happen.

3. Home buyers can lose out on value

High serviceability buffers have been criticised for unnecessarily delaying some buyers from receiving a home loan. If the housing market is performing well, six months or a year passing can mean a property becomes far more expensive. High serviceability buffers often mean that buyers are forced to wait longer to improve their application (through a larger deposit or increased income), and potentially cannot afford the same property by the time they are in a position to be approved for a buffer-adjusted loan.

How much can you borrow?

Most lenders will generally use some variant of the following formula to calculate borrowing capacity.

After Tax Income - Living Expenses - Financial debts and commitments = Monthly surplus.

If your monthly surplus is above the amount you will need to make in repayments with the buffer added to the interest rate, your application has a high chance of being approved.

Lenders may also consider the Loan to Value Ratio (LVR) of an applicant, as well as the aforementioned Debt Service Ratio (DSR). A high LVR and/or DSR will hurt an applicants chances of approval.

Many lenders use the Household Expenditure Measure (HEM) to work out living expenses in conjunction with bank statements and account activity. This is a base level of household expenditure, based on several factors including an applicant's age, where they live, number of dependents and level of spending among many other factors.

The HEM is supposed to represent the minimum level of spending a given individual will need for their living expenses. If the applicant's past six months of living expenses equate to a lower figure than HEM, the lender will use the HEM to estimate their living expenses instead of their account history.

Some lenders also only take a proportion of certain types of income into account. For example, since rental and some other investment incomes can fluctuate, many lenders will only include 80% of this income, or less.

It's important to remember that just because you are likely to be accepted for a home loan of a certain amount, doesn't necessarily mean it is a good idea.

If you are considering entering the property market, our home loan borrowing power calculator is a useful way to get an accurate sense of how much you can borrow.

The information contained on this web site is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser. If you or someone you know is in financial stress, contact the National Debt Helpline on 1800 007 007.