Could you be locked into your mortgage?

Some borrowers may be unable to refinance with new lenders if the authority that supervises Australian banking institutions re-introduces a serviceability “floor rate” for new home loans.

Australian Prudential Regulation Authority (APRA) chairman John Lonsdale told the AFR this week that he believes the banks have sufficient capital buffers to withstand the challenges of falling house prices and rising inflation. However, if the economy was to falter he may be open to adjusting macroprudential policies.

“If the facts change, our views might change too,” Lonsdale said.

What are the current regulations governing home loans?

Macroprudential policies define the rules and mechanisms that ensure financial institutions do not take excessive risks or restrict the opportunity for steady economic growth.

The independent statutory authority that sets this framework - and is accountable to the Australian Parliament - is APRA.

Before the Reserve Bank of Australia (RBA) began slashing the cash rate from mid-2019, there was a 2 per cent buffer that all Aussie lenders were obliged to add to their mortgage interest rates when assessing a new home loan. 

In addition, APRA had established a minimum interest rate floor of 7 per cent. This meant that any new home loan customer would have to be assessed at a serviceability rate of at least 7 per cent before being approved.

However, in July 2019 APRA altered its guidance on these serviceability assessments for authorised deposit-taking institution’s (ADIs) residential mortgage applications. While the buffer was increased to 2.5 per cent - and then 3 per cent in October 2021 - the serviceability floor was removed entirely, allowing the banks to review and set their own approval margins.

How rising interest rates may influence the rules

Economists, along with the big four banks, are tipping that the Reserve Bank of Australia (RBA) will continue to deliver further cash rate hikes in 2023. This week, Deutsche Bank’s Australia chief economist Phil O'Donaghoe revised the institution’s long-term outlook.

“It is clear that our previous expectation of a 3.35 per cent terminal rate for Australia is insufficient,” O’Donaghoe said in a note to clients on Monday.

“We now look for the RBA cash rate to rise to 4.1 per cent by August, with 25 basis points hikes in each of February, March, May and August. In other words, we add 75 basis points of hikes to our previous terminal RBA call.”

APRA is expected to release a new policy paper on its housing lending rules later this month. If interest rates continue to rise, the regulator may consider reducing the buffer rate below 3 per cent, to support credit inflows.

For example, the lowest variable home loan rate currently available on RateCity is charging 3.99 per cent interest. Factoring in the existing buffer rate of 3 per cent, the minimum serviceability rate would be 6.99 per cent. This would slip to 5.99 per cent if the buffer was reduced to 2 per cent.

However, a reduction in the buffer rate may also lead to a reintroduction of the 7 per cent serviceability floor. If this rule was also reinstated, existing borrowers may find themselves locked into their current mortgages as it would likely be difficult to refinance with a different lender, considering serviceability minimums were much lower when they entered into the housing market.

Falling house prices add pressure to the pain

CoreLogic’s Daily Home Value Index (HVI) hit a decline of -8.40 per cent in January 2023, which is officially the largest drop-off on record. The firm expects housing market conditions to remain soft over the coming months. 

This depreciation may reduce the equity some borrowers have accumulated over the past few years, further stifling their serviceability credentials in the eyes of prospective refinancing lenders. This is sometimes referred to as mortgage prison.

Being in mortgage prison makes it very costly to switch lenders, as you are likely to have to pay Lender’s Mortgage Insurance (LMI), which can climb into the tens of thousands of dollars. Those most at risk of mortgage prison are:

• Borrowers who purchased at the peak of property prices in their area; and
• Borrowers with small deposits, such as first home buyers.

What can you do to improve your situation?

The best actions to take in response to potential changes to lending rules, rising interest rates and declining property values will depend on your household’s financial position and your personal objectives. A few of general tips you might consider include:

• Ascertain your home’s equity - get a free property report to estimate your current home value
• Compare a range of different home loans if you’re eligible to refinance
• Consider making extra repayments and/or using offset accounts to build mortgage buffers
• Check your credit score to see where you stand
• Consider contacting a mortgage broker for advice that’s more specific to your financial situation

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