Lending update: interest rates and borrowing capacity improvements

By September 29, 2020 September 30th, 2020 Mortgages

The government made an important announcement last week. This change could substantially increase your borrowing capacity in the next year. It is perhaps the most significant change that has occurred in the last decade and will further fuel property price growth.

I also wanted to update you on interest rates, particularly in light of recent expectations that the RBA will soon cut rates again.

A positive change for investors and the property market

In 2009, the government re-wrote the laws governing the provision of loans. This required mortgage brokers and lenders to ensure that any new loans provided to borrowers were ‘not unsuitable’.

The background is important

Since the introduction of this new legislation, the government (ASIC) has been gradually tightening the laws, particularly over the last 3 to 4 years. In October 2018, I compared the loan application process to a forensic investigation (see below). This was not an exaggeration.

A few months ago, even the Governor of the RBA agreed that the tightening of credit rules had gone too far. There have been many examples of banks trawling through bank statements questioning small ($20) expenses. This pedantic approach added very little to the quality of the credit assessment.

Your current spending tells me little about your ability to repay

Perhaps the most significant recent event was Westpac’s success in defending an action initiated by ASIC regarding its alleged non-compliance with the credit laws. This case is now referred to as the ‘Wagyu and shiraz’ judgment. That is because Justice Perram said “I may eat Wagyu beef everyday washed down with the finest shiraz but, if I really want my new home, I can make do on much more modest fare…”.

When faced with the decision of whether to go out to dinner or make a mortgage repayment, almost everyone will make the right decision. To some degree, a high level of discretionary spending is arguably strong evidence that you have surplus cash flow that you could otherwise divert towards loan repayments.

The upshot is that 100 pages of ASIC guidance has created a very bureaucratic, inflexible, one-size-fits-all approach to assessing loans. This creates undue complexity, long delays, avoidable costs and sometimes perverse outcomes. No one wins.

The main proposed change is…

The main change proposed by the government is that lenders will be allowed to rely on information provided by borrowers, unless there are reasonable grounds to suspect that information is unreliable. This means the bank can ask you about your expenses and, in most situations, rely on the answer you provide. This avoids them having to trawl through your bank statements, like they do now. When formulating your answer, you can give consideration to what your “base level expenses” are. That is, all fixed and non-discretionary expenses. This may better represent your capacity to afford any proposed loan repayments.

In addition, the ‘Wagyu and shiraz’ judgment confirmed that it is acceptable for banks to use “benchmark expenses” when assessing a loan application. In this situation, some banks may not choose to ask you what you spend. The banks have a substantial amount of data about what their customers spend, which should allow them to determine reliable benchmarks.

Criticisms and what I hope happens

This recent announcement by the government has attracted a lot of criticism. The main concern is that shifting the responsibility from the bank onto the borrower could invite lenders to repeat past mistakes i.e. giving loans to people that cannot afford it.

It is my view that the lending regulation should never be relaxed back to pre-2009 levels. Governance and oversight at that time was far too lose. Conversely, its current form is too restrictive. The correct level is somewhere in the middle.

Banks and brokers must ensure they only give loans to borrowers that can afford it and where it is in their best interest. Sometimes, declining a loan (or declining to help someone) is in their best interest.

At the same time, regulation must allow some discretion so that different borrowers are assessed in different ways. For example, I think we all can agree that a borrower that has $10 million of property plus $5 million in cash can probably safely borrow $1 million, almost irrespective of their current income, expense levels and age.

This could increase borrowing capacity by 20-30%

Any changes will not come into effect until after 1 March 2021, at the earliest. Lenders have not yet responded to the government’s announcement. Therefore, it is impossible to ascertain what impact these changes will have on borrowing capacity, but it’s likely to be material.

My initial calculations indicate that it could increase a borrower’s capacity by as much as 20% or 30%.

An increase in loan volume will fuel property price growth

Last week, I wrote that I expect property prices to rebound strongly over the next 12 to 18 months (i.e. by 10% plus). This change in lending policy strengthens my expectation. 

I have previously explored the relationship between loan volume and property price growth (see here). There is a strong positive relationship. This increase in borrowing capacity will lead to higher loan volumes and inevitably create upward pressure on property prices.

2021 is shaping up to be a good year for property investors.

Update on interest rates and fixed rates

There are two important matters I wanted to highlight.

(1) RBA rate cuts

There has been a bit of talk about the RBA cutting the cash rate from 0.25% to 0.10% p.a. Whilst this might sound like good news for borrowers, I don’t think it will have any impact on mortgage interest rates.

The main reason the RBA wants to cut rates is to reduce the government’s borrowing costs. The government recently issued 10-year bonds at a cost of circa 1% p.a. The expectation is that the RBA would like to reduce the government’s borrowing costs from 1% to closer to 0.50% p.a. It can do this by cutting the cash rate and perhaps implementing additional quantitively easing.

The federal government will deliver its budget next Tuesday (6/10/20) night and it will almost certainly include a lot of government spending funded from debt. As monetary policy initiatives (cutting rates) have been exhausted, it is now up to governments (fiscal policy) to spend money to stimulate an economic and jobs recovery. Government can do that effectively because the cost of debt is so low. But the RBA must ensure the Australian government’s cost of debt is globally competitive and comparable.

The upshot is that I don’t anticipate that the banks will pass on all or any of future cuts to the RBA cash rate. Variable mortgage rates are unlikely to be impacted.

(2) Fixed rates

For the first time in over 20 years, I have fixed some of my personal mortgage rates. Historically, I have not been a fan of fixed rates, as I have always preferred to maintain as much flexibility as possible. As an active investor, I tend to refinance my loans every 2-4 years (as discussed here).

Also, the chart below that I drew for my latest book, Rules of the Lending Game, demonstrates that in most situations, fixed rate borrowers are worse off.

rates

However, this is a unique time in history because we know the variable interest rate floor. That is, we know that it’s almost impossible that variable rates will decrease (materially) below current levels, especially home loan rates. As such, variable rates will only rise in the future (albeit maybe not for a very long time). That makes comparing fixed and variable rate options a lot easier.

3-year fixed rates are, on average, much lower than the current variable rates:

  • 0.30% to 0.50% p.a. lower for principal and interest home loans; and
  • 0.50% and 0.80% lower for interest only investment loans.

As such, fixing your mortgage for 3 years can provide some attractive interest rate savings over the next 3 years.

There are some good reasons not to fix including preserving the ability to make large principal repayments, if you plan to sell a property, to retain an offset and so on. Therefore, I suggest you get some advice before making the decision to fix.

Powerful combination of higher borrowing capacity and low fixed rates

Fixing interest rates on existing debt and waiting for these aforementioned borrowing capacity changes to be rolled out could result in substantially positive outcomes for investors. It is important that you are taking full advantage of the opportunities this situation provides.