Update: On 6 October 2021, the regulator announced that banks must now test whether a borrower can afford a loan based on principal and interest repayments at current rates plus a buffer of 3% (previously 2.5%). As this measure requires a cash flow analysis, we feel it’s more meaningful than imposing a debt-to-income ratio cap (as discussed below).
Federal Treasurer, Josh Frydenberg has asked the Council of Financial Regulators to investigate the fact that credit growth is materially outpacing growth in household income and to advise on any policy responses.
In lay terms, the Treasurer is worried that people are borrowing too much money compared to their incomes and that could be risky for the economy.
Increase in home lending is pronounced
It has been well documented that house prices in Australia have been rising at a fast pace over the past year. But this isn’t unique to Australia. This is also a global phenomenon, as illustrated in Knight Frank’s Global House Price Index report released last week. This report ranks the house price growth in 56 countries and Australia ranks 18th.
It is higher loan volumes that have caused higher property prices. The ABS chart below shows that most of the increase in lending has been driven by owner-occupiers (being the dark blue line), not investors.
The monthly volume of home loans has been rising significantly since mid-2020. The average volume of lending between December 2020 and August 2021 was $21.7 billion per month. The average for the 10-year period prior to June-2020, was only $11.6 billion per month.
Approximately 60% of the increase in lending over the past 9 months has been driven by an increase in the number of borrowers. And 40% has been driven by an increase in the average loan size i.e. people borrowing more. This makes sense as higher income earners have largely been (economically) unaffected by the Covid lockdowns.
Level of household debt is a worry
The chart below illustrates how the level of household debt (blue line) has increased over the past three decades. The green line depicts the interest cost of this debt. The interest cost has remained relatively contained for the past decade, thanks to falling interest rates.
Household budgets will clearly be more sensitive to future interest rate increases because they have more debt. This means that any future increases in the RBA Cash Rate will be more effective in containing inflation (by cooling consumer spending). As such, it is entirely possible, even likely that interest rates may never return to pre-GFC levels. That is, it’s possible that interest rates will permanently remain below 6% p.a.
The upshot of this is the government is rightly concerned about households’ higher indebtedness. This may be acceptable whilst interest rates are unusually low, but it could cause problems for some borrowers when interest rates inevitably rise.
Likely intervention: income to debt cap
The banking regulator considers a high debt-to-income ratio as anything above 6 i.e. borrowings greater than 6 times your family’s gross annual income. Therefore, if your family’s income is $200k p.a. and you have borrowings more than $1.2 million, the regulator considers you to be a riskier borrower.
The chart below (from an APRA report) highlights that high debt-to-income lending (dark blue) has increased since last year. In fact, it grew by 2.8% in the June 2021 quarter which is the highest increase on record.
It is this cohort of borrowers that I expect the regulator to target. It can do so by instructing the banks to reduce lending to borrowers that have high debt-to-income ratios i.e. greater than 6 times, which I think is prudent.
Asset-rich, income poor are locked out of the borrowing market
Asset-rich, income-poor borrowers will further be disadvantaged. As I wrote several months ago, banks only lend against income, not assets. That means if you have $20 million of cash in the bank and no job, most mainstream banks will not lend you a cent! Inflexible lending rules do not allow a bank to consider your asset base as a source to fund loan repayments (only income). Of course, this is nonsensical.
Consider an example where a borrower owns their home worth $1 million, an investment property worth $1.2 million, a share portfolio worth over $2 million, $500k in cash savings and has zero debt. For lifestyle reasons, the borrower only works casually and earns $20k p.a., but has the capacity to work full-time, if required. In this situation, this borrower has almost no borrowing capacity. Practically, this investor could borrow safely.
The point I’m attempting to make is that implementing restrictions such as a debt-to-income caps is often necessary and prudent. However, lenders must have the flexibility to work outside of these parameters where appropriate. Unfortunately, they almost never have this flexibility or are unwilling to exercise it.
Higher income borrowers are in the box seat (again)
Most people with a family income of $1 million, for example, probably wouldn’t want or need to borrow materially more than $6 million, so the implementation of a debt-to-income cap will not have any impact on their plans.
However, borrowing capacities for lower income earners will be adversely impacted. A restriction on borrowing capacity will retard their ability to afford a house in their desired location and/or their ability to invest in property.
Whilst this isn’t an unacceptable outcome in isolation (as borrowing say 10 times income, for example is rarely a good idea), it will unfortunately exacerbate wealth inequality.
What does this mean for the property market?
It is my view that any change to debt-to-income ratios will probably not have any measurable impact on blue-chip, investment-grade locations. There are enough borrowers with strong financial positions to underpin demand for investment-grade property.
However, expected tightening in lending rules will likely impact locations that are populated with a higher proportion of lower income earners.
