rising inflation

How Does Rising Inflation Affect Your Borrowing Power?

The rate of inflation in Australia has been rising more rapidly that expected. This is due to the economy making a speedy recovery from the COVID-19 pandemic.

To help slow down inflation, the Reserve Bank of Australia (RBA) has been hiking the cash rate. This caused interest rates on home loans, credit cards and savings accounts to increase.

We’ll look at what inflation is and why it matters for interest rates. We will also see how rising inflation impacts your borrowing power and what steps you can take to boost your borrowing capacity.

What is Inflation and Why is It Important?

Inflation is defined as the increase in the prices of goods and services. Inflation rate is the rate of growth at which this increase occurs. The RBA’s job is to manage the inflation target. Along with Australia’s central bank, the RBA is responsible for maintaining the country’s economic health.

The RBA wants to maintain a rate of inflation of about 2 to 3%. This percentage is called the inflation target. This is decided using the Consumer Price Index (CPI) which is independently calculated by the Australian Bureau of Statistics once every quarter.

This index measures the change in the price of goods and services, including food, housing, and transport. Sustainable economic growth can be reached by managing the inflation rate, however, earlier this year, Australia recorded an annual inflation rate of 5.1%, way past its intended inflation target.

What is Cash Rate and How is It Related to Inflation?

The cash rate is the interest rate charged on overnight loans between lenders, which is determined by the RBA. If inflation creeps higher than the target rate, the RBA tends to raise the cash rate to restrain economic growth. The cash rate is, essentially, the cost of borrowing money and affects interest rates on products like home loans, car loans, and credit cards.

cash rate

How Does Inflation Affect Interest Rates?

The high inflation rate has put pressure by increasing the cost of living. In turn, the RBA started increasing the cash rate to bring inflation down to its target level. This year’s cash rate hikes have, in turn, raised interest rates. Rate rises increase the cost of borrowing money, which helps to reduce demand for goods and services. So, rising inflation also typically means rising interest rates.

How Does Rising Inflation Impact My Borrowing Power?

Rising inflation causes interest rates to increase, which in turn causes borrowing power decrease. This is because repaying a loan will become more expensive. Borrowing power is an estimation of how much money a lender is likely to let you borrow for a home loan.

Lenders determine your borrowing power by considering your income, assets, liabilities, household expenses and home loan deposit size. Hopeful home buyers may find that as interest rates rise, the amount they are able to borrow falls.

However, house prices are declining in some areas across the country like Sydney and Melbourne, meaning property prices could become more affordable even as interest rates rise. It means your borrowing power may be less affected if you’re buying in an area where property price growth is improving.

How Can I Increase My Borrowing Power?

Here are some tips for raising the amount you can borrow for a home loan.

1. Claim all your income

Upon applying for a home loan, declare all your income on your application. This can help increase your borrowing power. While income streams like employment income are the obvious sources of income, don’t forget to include details of your superannuation or any government payments you receive.

2. Pay down other debts

It is a good idea to pay off any credit card debt, a car loan, or a personal loan before applying for a home loan if you want to up your borrowing power. From a lender’s point of view, the less debt you’re in, the more money you’ll have to repay a home loan.

3. Trim down your expenses

Take note of your monthly expenses and find areas reduce spending will not only save you money but increase you borrowing capacity as well. For example, cutting down on online shopping months leading up to your home application or comparing health insurance policies to see if there are better deals elsewhere.

4. Focus on your saving habits

Providing a lender with evidence of genuine savings is typically a requirement for your home loan application. Having consistent saving habits is good, especially when applying for a mortgage. Good saving habits can help boost your borrowing power. An example would be an automatic direct debit to your savings account on payday. This can reduce any temptation to spend the money otherwise destined for your savings.

5. Reduce your credit card limit

Consider reducing the limit of your credit card before you apply for a home loan. In the eyes of a lender, a borrower with a lower credit card limit has less potential debt than a borrower with a higher limit, boosting their borrowing capacity.

6. Save a sizeable deposit

Save up a deposit of at least 20%. This can boost your borrowing power. Not only will saving a 20% deposit mean you can avoid paying Lenders Mortgage Insurance (LMI), it means you won’t have to borrow as much money for a home loan.