Finance Market Update - 2 August 19
Changes in how banks assess applications means people can borrow more, and people are borrowing and spending more as a result. In this fortnights update we discuss what these changes are, how that has impacted property prices.
A lower hurdle to jump over
When you go and apply for a mortgage the bank will test your ability to repay the loan at a higher interest rate than what you are actually going to get.
The idea behind this was that inevitably rates were going to rise and so banks should be able to know that once they do rise you will still be able to afford the repayments and debt.
Since 2014 APRA has forced the banks to assess mortgage applications with a minimum interest rate of 7% (industry standard 7.25%) even though most people had a rate well below that.
With the RBA cutting the cash rate to 1% and most of the developed world having their central banks rates at or even below zero, APRA has astoundingly come to the realisation that mortgage rates are not going to get to 7% anytime soon, and a more appropriate way to stress test a borrowers repayment power is by adding a buffer on the real rate they get.
From now on when you apply for a mortgage a bank will add a 2.5% buffer to the actual interest rate stated on your contract, instead of the arbitrary 7% rate.
For example, if you are getting a mortgage for you and your family to live in (referred to as Owner Occupied), you have a good deposit (equal to 20% so LVR is 80%) and you want to pay down the debt and interest each month (known as Principal & Interest Repayments) you could realistically, as at time of writing, expect to get a competitive rate of around ~3.40% (*could be better or could be higher depending on many factors). The bank will now assess your ability to repay each month using an interest rate of 5.9% (3.40 + 2.50) instead of 7%.
That lower rate being used in the assessment means the amount you can borrow goes up.
This is because repayments at 5.9% are lower than if the rate was 7% so the bank will allow you to borrow more because you can now ‘afford’ to repay more each month.
There is a caveat here – if the real rate plus the buffer is below 5.75% the banks will use 5.75% as the rate. This is called the ‘interest rate floor’ and is basically a failsafe for APRA to see in place for when rates actually get below that point. A few banks have a lower interest rate floor but on balance 5.75% is being used.
I’ve written before about how banks move the goals posts and the changes in assessment criteria are a prime example.
This change will be welcome news for first home buyers and people looking to upgrade or invest as it effectively gives them the ability to take out a larger mortgage and buy a bigger and better property.
Certain estimates put the increase in borrowing power up by 10% or more. That means a borrower who could before borrow $900k can now get a loan for just under a million dollars, and the type of property can be quite a step up for those kind of price jumps.
But it is important to remind our-selves here that before the royal commission that same borrower could have got a loan for more than a million, in half as much time and while providing half as much information.
Things changed a lot during the Royal Commission, and one of the key things was borrowing power. So, in a way this assessment rate change is kind of a rebalancing act the regulators are doing because the banks lending got so tight.
It is also not a coincidence that property prices also started falling at the same time as borrowing power was weakening.
If you can’t borrow as much then your hand will come down a few waves earlier at an auction because you cant buy at the higher price.
This is what happened during the mini credit crunch over the past year. People couldn’t borrow as much so they couldn’t buy as expensive properties as they otherwise might have, which depressed property prices.
A lot of hands were coming down at auction earlier than they would have when the banks were lending like there was no tomorrow.
Now with the assessment rate changes, while the levels might not be back at the hysterical tops pre royal commission, borrowing power is still considerably improved on where it has been over the past year.
More money, more spending, more problems
Evidence of change from the assessment change is already playing out in the market.
Across Sydney the clearance rates have spiked, up 40% compared to this time last year, credit growth is up, and open homes are busy again.
People are optimistic about the prospects of property and can now borrow a bit more, and bit more easily, to buy a bit of a nice nicer property.
All of this likely means we are past the bottom of the property market in this cycle, but headwinds remain against another boom and we will probably see sideways movement in prices before gradual growth to recorrecting in prices.
For the second month in a row (May and June) there has been positive growth in house prices. In Sydney that has been very modest at 0.1 and 0.2% respectively, according to Core Logic, but that is positive nonetheless, a further verification that the bottom has been reached.
Clearly people are willing to buy property again, but one worrying point with this new boost of buying is that many people are borrowing with LVR's over 80% and having to take out LMI (Lenders Mortgage Insurance) as a requirement. The country’s biggest LMI provider, Genworth, announced this week that in the first half of 2019 they saw a 20% increase in 'premiums' (i.e. LMI insurance policies) being written.
It is important to understand that LMI protects the lender, not the borrower, in the event of a default on the loan. It means the insurer (like Genworth) would pay the bank if a borrower stopped paying them, but the borrower would still be liable for the loan amount in full.
This is worrying because of the scenarios that require a borrower to take out LMI must have also increased.
Those scenarios include: People are refinancing and having to take out LMI because the value of their property has dropped below an 80% LVR (i.e. they paid too much and have a big debt), first home buyers with a small deposit are buying property (in itself a good thing, but not when overburdened) but having to take out this cost, or lenders are happy to write larger loans (since the royal commission) which means people have more debt.
As property prices start an upward trend we should remain cognisant of who is buying and how they are borrowing.