Australia's financial regulator, with the backing of the federal government, has moved to tighten residential borrowing buffers in a bid to put a brake on the red hot housing market.



The Australian Prudential Regulation Authority (APRA) has written to all banks advising them to increase the rate at which they stress test mortgages from 2.5% to 3%.



The change, which will take effect at the end of October, means new loans could be tens of thousands of dollars less than would otherwise have been approved.



APRA Chair Wayne Byres said this was a targeted action designed to reinforce the stability of the financial system. He said medium term risks to financial stability "were building".



“More than one in five new loans approved in the June quarter were at more than six times the borrowers’ income, and at an aggregate level the expectation is that housing credit growth will run ahead of household income growth in the period ahead. With the economy expected to bounce back as lockdowns begin to be lifted around the country, the balance of risks is such that stronger serviceability standards are warranted,” Mr Byres said.



KR Peters Director Peter Nicolls said the home loan buffer would provide APRA with the comfort that when interest rates rise, borrowers will not be left in a vulnerable position and experience hardship making repayments in the years ahead.



"The new 50 basis point increase will reduce maximum borrowing capacity on a loan by around 5%," Mr Nicolls explained.



"The 3% buffer will have a bigger effect on investors than it will have on owner-occupiers based on the assumption that investors will be already committed to existing loans."



Mr Nicolls said the increase to buffer margins would not have a drastic impact on property prices.



Federal treasure Josh Frydenberg welcomed APRA's direction saying it was important to be mindful of the balance between credit and income growth to prevent the build-up of future risks.



Mr Byres said APRA would continue to closely monitor risks in residential mortgage lending and take further steps if necessary.