Australian banks have reportedly increased the home loan "buffers" that they use to assess potential home buyers as to whether they will be able to meet their repayments when interest rates inevitably rise.
Having recently been issued warnings from the Australian Prudential Regulation Authority (APRA) and the Reserve Bank of Australia (RBA) not to relax their lending standards in light of the low interest rate environment, the major banks are increasing their "buffers" to better ensure payments will be possible in the future.
When dealing with prospective borrowers, banks such as Westpac (ASX: WBC), Commonwealth Bank (ASX: CBA), NAB (ASX: NAB) and ANZ (ASX: ANZ) have always added an interest rate buffer on top of their current home loan rates, to test whether the customer will be able to afford repayments should interest rates increase. Although there has been speculation that interest rates could be cut further from the current 2.5%, the rate will inevitably increase eventually as the economy begins to regain strength.
As reported by The Australian Financial Review, senior sources within the banks have confirmed that, given the historic low cash rate and increased demand for home loans, a 2% buffer has become typical. In comparison, buffers of between 1.25% and 1.5% were usual last year.
When a prospective customer applies for a home loan, the banks will test whether they will be able to repay the loan if the underlying interest rate were to increase 200 basis points or 2%. As a mortgage is usually taken out over two decades, the chance of interest rates rising greater than 2% is highly likely.
For example, despite the possibility of interest rates falling to as low as 2% in the near future, the cash rate (the cash rate excludes the margins recognised by the banks) has remained above 4% for much of the last 20 years, as can be seen from the graph below:
Foolish takeaway
The risks facing the Australian economy have been the topic of much discussion lately, where it is feared that a property price bubble could be the result of inflated demand with the low interest rates. It is also feared that should the banks relax their lending standards and borrowers are unable to repay their debts, a situation similar to the sub-prime crisis could be repeated.
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Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned in this article.
