The prudential regulators have shaken the branches when it comes to investment lending in fact I haven’t seen this level of lender reaction since the GFC and maybe not even then. The two main impacts are interest only and living costs.
Interest Only (IO) loans were the natural option for any borrower using a negative gearing strategy. It allowed you to quarantine the debt, maximise tax deductions, borrow more and simply sit back and as property values rise you develop more equity and you can buy another property. While negative gearing is being defended by the LNP government their own appointed regulators have applied a meat axe. The press has been full of reports of borrowers with interest only loans never paying them off and paying a fortune in interest ….which is exactly what current negative gearing tax arrangements promote. Now there are also stories of owner occupiers with interest only loans – there are three legitimate reasons why this may come about:
- Virtually all construction loans are interest only during the construction – they normally revert to P&I ( principal and interest ) once construction is completed.
- An owner occupier may want to reduce their repayments for a period for example during maternity leave, or a period of unemployment or study etc.
- The borrowers may get into the property market but intend to rent the purchased property out and purchase another PPOR ( primary place of residence ) in the mid/short term eg: 5 years. In this case the ATO treatment of negative gearing means the buyer would be very ill-advised to not use an IO loan and a 100% offset account, making additional payments equal to at least the P&I level into the offset account.
Any lender or broker arranging an IO loan for an owner occupier outside of these situations should not be in the business.
However the regulators have waded in with very little understanding of the reality. They have decided that borrowers not paying off loan is a bad thing, despite the government promoting it through the ATO. They believe that all borrowers will remain with their existing lender and have to make very high repayments As a result they have forced lenders to reduce the number of IO loans within their portfolio, resulting in:
- increased interest rates,
- lower LVR ( loan valuation ratio ), and
- tighter servicing – brought about by instead of using the lower IO repayments when calculating borrowing capacity they have to use P&I repayments over the remaining term of the loan. Investment loans are typically 25 year term with an IO period e typically 5 years with an addition 5 year roll over. Remember, the investor using negative gearing wants the loan to remain unpaid so at the end of the 10 years they simply refinance the loan to another lender for another 10 year IO period. However the regulators ignore that reality and insist that the lenders calculate borrowing capacity at 15 year term P&I – and this imposition has brought about the reality of what they were supposedly trying to protect us from. With much tighter servicing investors are trapped – they don’t qualify for their existing loans and so they cannot refinance to new lender with a new IO term. They are forced to allow their loans revert to P&I. We have clients looking down the barrel of $7,000 + per month in additional repayments simply because they can no longer refinance.
The other major impact imposed by the regulators is ‘living costs‘. In the past lenders used a minimum living cost based on the Henderson Poverty Index …in other words, if you were really struggling what is the minimum you could spend to live. Westpac just got thumped with a $35 million fine for this but if the regulators looked a little closer they would find that this was the rule with most lenders. This then evolved to use a much higher base with the HEM ( Household Expenditure Measure – based on ABS) but that’s not good enough for the regulators. They are now insisting that lenders/brokers look at each individual applicants actual living costs ie: audit your bank statements. The silliest part of this is that they make no allowance for the fact that many living costs are discretionary eg: expensive wines in place of goonies, private schools in place of public, gym fees in place of walking in park. This lunacy is then compounding the servicing issues, meaning many people are missing on new homes, or refinancing to better deals just because they have an expensive existing lifestyle.
My argument on rent is usually more aimed at buyers who have limited savings, these are typically young couples or people who have experienced set-backs such as illness or divorce and the most important ingredients here are LMI ( lenders mortgage insurance) and stamp duty. Borrowers with the bare minimum 5% deposit who live in states with no stamp duty concessions are really struggling to get into the market. In most cases 5% is no where near sufficient – for example in NSW a house in a regional area with a deposit of $17,500 on a $350,000 house does not even begin to cover stamp duty $10,000 and LMI $12,000.