(Adds APRA chair quote, background) SYDNEY, May 21 (Reuters) -...

(Adds APRA chair quote, background)

SYDNEY, May 21 (Reuters) - Australia's prudential regulator on Tuesday proposed dropping requirements for banks to use a minimum 7% interest rate when assessing borrowers' ability to service loans, in a move that would likely lift customers' maximum borrowing capacity.

The removal of the cap, first introduced in 2014, comes amid a sustained drop in house prices, record-low credit growth, a slowing economy and expectations the central bank would this year cut its benchmark interest rate from an all-time low of 1.5%.

"With interest rates at record lows, and likely to remain at historically low levels for some time, the gap between the 7 per cent floor and actual rates paid has become quite wide in some cases – possibly unnecessarily so," APRA Chair Wayne Byres said in a statement.

Instead of the 7% floor, the regulator is proposing banks be allowed to set their own minimum interest rate floor in their serviceability assessments. It added banks should use a minimum 2.5% buffer on top of their loan rates in these assessments.

The regulator has begun a consultation period that closes on June 18, APRA said.