Earlier today the Australian Prudential Regulation Authority (APRA) issued a letter to all authorised deposit-taking institutions (ADI) regarding consultation on revisions to prudential practice guide APG 223 residential mortgage lending. While that may not mean very much to readers specifically the letter relates to APRA’s requirement for lenders to assess a mortgage on the ability of the borrower to repay at a mortgage rate greater than 7%.
By way of background, in December 2014 APRA wrote to all of the ADIs with a number of new guidelines for sound mortgage practices. One of the measures specified by APRA at that time was that prudent ADI’s serviceability assessments should incorporate a buffer of at least 2% above the loan product rate and a minimum floor rate of at least 7%. APRA further noted that prudent practice would maintain a buffer of 2% and floor rate above 7%. As a result, many lenders used an assessment rate on mortgages of 7.25%.
The lending environment has changed quite a lot since that time. We have seen the reintroduction of differential mortgage pricing for owner occupiers, investor and interest-only borrowers. Lenders have become much more focussed on responsible lending requirements and as a result they are asking borrowers more detailed questions about their financial positions and moved away from using the HEM Index.
The differential pricing in mortgages and the declines in interest rates since the end of 2014 are really the major factors that have made the greater than 7% buffer inappropriate for the current lending environment, as an example owner-occupiers wanting a principal and interest mortgage can now comfortably borrower with a mortgage rate below 4%. If someone is offered a mortgage at 3.9%, for example, they are currently being assessed on their ability to repay a mortgage at an interest rate of 7.25%. Of course a mortgage is a 25 to 30 year commitment. Over that period interest rates will fluctuate, however, at the moment it is a low interest rate environment with low inflation and low wage growth.
The market expectation is that interest rates will fall further however, under the current policy, lower interest rates (and mortgage rates) would not necessarily enable new borrowers to take out a mortgage. The reason being those that couldn’t qualify for a mortgage previously would still be unable to qualify despite the lower rates.
What APRA is now proposing the following revisions to its lending guidelines:
- Remove the quantitative guidance on the level of the serviceability floor rate, i.e. the reference to a specific 7%. APRA will still expect ADIs to determine, and keep under regular review, their own level of floor rate, but ADIs will be able to choose a prudent level based on their own portfolio mix, risk appetite and other circumstances;
- Increase the expected level of the serviceability buffer from at least 2% (most ADIs currently use 2.25 per cent) to 2.5 per cent, to maintain prudence in overall serviceability assessments; and
- Remove the expectation that a prudent ADI would use a buffer ‘comfortably above’ the proposed 2.5 per cent, to improve clarity of the prudential guidance.
The reasons detailed for APRA about these proposed changes are:
- The low interest rate environment is now expected to persist for longer than originally envisaged. This may mean that the gap between actual rates paid and the floor rate may become unnecessarily wide; and
- Compared to 2014, when a single standard variable rate was used as the basis to price all mortgage loans, ADIs have introduced differential pricing for mortgage products. The merits of a single floor rate are therefore less obvious, particularly as it will be most binding on owner-occupiers with principal and interest loans, and least binding on investors with interest-only loans.
Under these proposed changes, if we look at the same scenario as previous, whereby someone is looking to borrow at an interest rate 3.9%. This borrower would previously been assessed on their ability to repay the mortgage at an interest rate of 7.25%, now they would be assessed on their ability to repay at a lower 6.4%.
The proposed APRA changes seem sensible given the interest rate environment with the expectation that rates will fall from here and remain lower for longer. Furthermore, since 2014 it has become much more difficult to get a mortgage, that is partly because of this serviceability assessment.
In a recent investor update to the market from ANZ it noted that the drivers of reduced borrowing capacity were driven by three factors: HEM changes (60%), servicing rate floor at 7.25% (30%) and income haircuts (10%). While these changes would ease some of the tightening around the servicing rate floor according to the ANZ statement at least 70% of the reduction in borrowing capacity sits outside of these changes.
In closing while these changes are welcome and will help some borrowers that can’t quite access a mortgage currently to get one, it is unlikely to result in an rebound in the housing market.
As shown by ANZ, it will still remain much tougher than in the past to get a mortgage because of other areas of tightening. Furthermore, the buffer of 2.5% above the mortgage rate is higher than the 2% buffer that was used prior to December 2014.
Overall for the housing market it will mean more people are able to get a mortgage. These proposed changes in conjunction with the uncertainty of the election now behind will potentially provide additional positives for the housing market. Furthermore, these changes may also ease some of the urgency for official interest rate cuts by the Reserve Bank. If housing can provide some additional economic stimulus, rate cuts may be less necessary.
Should these changes be implemented it would potentially slow the declines further and may result in an earlier bottoming of the housing market (we currently expect the market to bottom in mid-2020). Despite that prospect, it will remain more difficult to obtain a mortgage than it has done in the past and we would expect that if/when the market bottoms a rapid re-inflation of dwelling values is unlikely.