It is important to note that lenders typically do not use their standard variable rate to determine your borrowing capacity. Instead, they employ an assessment rate to calculate the amount you can borrow.
What is an Assessment Rate?
An assessment rate is a higher interest rate used by lenders to evaluate a borrower’s financial situation when applying for a loan. While lenders have their standard variable rates for home loan products. However, the assessment rate is higher to provide a sense of security and minimise risks against future interest rate increases. The assessment rate significantly determines your borrowing capacity, affecting your ability to make monthly repayments according to the lender’s criteria.
The assessment and actual interest rates a borrower pays are distinct. They determine the real interest rate by several factors, including the assessment rate, the lender’s risk assessment, and the borrower’s credit score.
Typically, borrowers with a higher credit score and a lower risk profile are eligible for a lower interest rate. In contrast, borrowers with a lower credit score and risk profile may be offered a higher interest rate.
How Do Assessment Rates Work?
The lender itself determines the assessment rate used by a lender. Lenders typically base their assessment rate on their standard variable rate, calculated using the cash rate set by the Reserve Bank of Australia.
Lenders usually add approximately 3.0 percentage points to the RBA’s cash rate to arrive at their SVR. This addition helps cover the funding costs associated with the loan and allows the lender to earn a profit margin. When evaluating your home loan application or serviceability, your lender generally applies an additional 3% above their SVR.
What is Serviceability Assessment?
The serviceability assessment is a crucial step in the home loan process where they evaluate the borrower’s ability to repay the loan. This assessment occurs after they submit a loan application before the credit check. It involves a review of the borrower’s income, expenses, and other factors to determine their capacity to repay them.
How Assessment Rates Impact Your Home Loan
The assessment rate has a significant impact on your loan application. It assumes that you will pay a higher interest rate than the actual rate on your home loan. Your application may get rejected if your income is insufficient to cover this additional interest.
The Australian Prudential Regulatory Authority played a vital role in the widespread use of assessment rates. In 2014, APRA required all lenders to apply a minimum buffer of 2% to the standard variable rates and set the minimum assessment rate at 7%.
Consequently, any home loan application you submit will get evaluated based on the assumption that you will pay at least 7% interest. It can pose challenges for individuals with debts, such as investors with multiple home loans, who may face difficulties obtaining approval for subsequent applications. Sometimes, lenders even apply higher assessment rates for home loans targeting investors.
However, it is essential to note that not all lenders use assessment rates. APRA’s mandate only impacted banks and Authorised Deposit-Taking Institutions, leaving room for smaller lenders who do not use assessment rates. These smaller lenders typically rely on their standard variable rates to assess your borrowing capacity. Consequently, opting for a smaller lender may increase your chances of securing approval for your home loan application.
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