Did you know that the Australian government monitors and reviews the lending criteria of the banks?

The Australian Prudential Regulation Authority (APRA) released for consultation ‘APG 223 – Residential Mortgage Lending’, a draft prudential practice guide intended to provide guidance to authorised deposit-taking institutions (ADIs) on “sound risk management practices” for residential lending.

Although the banks will not follow it exactly, it’s a fair bet that this guide will play a big part in the way that home loans are approved in the coming years. The guide doesn’t affect non-bank lenders as they are not classed as ADIs and, therefore, aren’t governed by APRA.

How they assess your borrowing power

When banks assess your ability to pay back a home loan they like to add a buffer to the interest rate to make sure that you can afford the repayments if interest rates rise.

In its practice guide, APRA has suggested that banks should also have a floor interest rate so that if rates are at historical lows (as they are now) then they don’t set people up to fail when interest rates do eventually go back to normal levels. For example, if home loan rates have a long term average of 7% and are currently at 4% then APRA would expect banks to make sure that customers could afford their loans if rates went up to 7%.

They’ve also suggested changes to the way your living expenses are calculated. Most banks use the Household Expenditure Method (HEM) to work out how much your living expenses are. To be honest, it’s basically the poverty line. So APRA thinks it makes sense to add a margin to the HEM figure if the borrower has a high income. I couldn’t agree more as long as the interest rate buffer used in serviceability is slightly decreased.

APRA suggested that banks should use all buffers when calculating serviceability or just one buffer as long as it is larger than normal. These buffers include:

• A higher assessment rate
• A floor rate
• Reduction or exclusion of unreliable income
• Higher living expenses (HEM) for high income earners.

You can use our how much can I borrow calculator to find out where you stand with several of our banks.

How your income is assessed

APRA made it clear in its draft guidance that it wasn’t a fan of unreliable income types. These include overtime, bonuses, commissions, rental income and anything else that is not a standard salary.

Banks already assess these in quite a restricted way so it could be that this stays the same or get even tougher.

I agree with APRA’s proposal that foreign income should be discounted to allow for exchange rate fluctuations and changes in international tax law.

APRA has said that it is against foreign currency loans to be given to people who are earning Australian dollars. Only foreign income streams should be matched with a foreign currency loan. Most banks have this policy already.

Low doc loans shouldn’t be approved if full income evidence is available. That makes sense. However, what the report raises by its very omission is that APRA doesn’t see low doc loans as a significant risk. The banks aren’t approving many of them and they are appropriately pricing and reducing the LVRs to manage their risk.

Interest only loans to home owners

APRA wants the banks to be cautious when giving a home buyer (owner occupier) an interest only home loan.

That makes sense for most customers. If you are buying a home then you want to pay it off and some people who want an interest only period are doing so because they are worried that they may struggle with the repayments.

APRA did acknowledge however that there were often good reasons to do so such as if someone intended to change their home into an investment property. As long as the banks can see a good reason then it’s not a problem.

In the past, many lenders didn’t give owner occupied loans an interest only period. Maybe we’re heading back in this direction.

Genuine savings

APRA has confirmed what we’ve all known for a long time: genuine savings is a very reliable indicator of a low risk borrower.

The regulator has suggested that ADIs should have a limited appetite for non-genuine savings and verify if gifts are actually repayable or not. Usually, this is in the form of a gift letter but it certainly isn’t a watertight form of proof.

If they are repayable then the repayments need to be included in their serviceability assessment.

95% home loans

APRA is concerned about loans over 90% of the property value as they see the potential for a much higher loss if the loan is not repaid.

The banks all require borrows to pay mortgage insurance for loans over 80% of the property value, with the exception of no LMI loans. So what are they worried about?

They believe that LMI should not be the sole mitigant for high LVR lending such as 95% home loans. Pricing and policy should be appropriate as well. In other words, APRA agrees that the banks should charge a higher interest rate for 95% loans. The good news is that some lenders offer low interest rates even at 95%.

Specifically, ASIC said that if someone is borrowing 95% then their borrowing capacity needs to be strong. This makes sense. A high income would allow you to pay off the loan quickly, effectively reducing the risk to the bank.

They want the banks to monitor their new approvals and report any spikes in the number of 95% loans they approve. We’ve seen this knee jerk reaction time and time again where one bank gets a huge volume of high LVR loans and then when they realise what is going on they all but shut down their over 90% lending.

Guarantor loans

We actually do a lot of guarantor loans so it is interesting to see what APRA has proposed. You see the banks have quite different policies in this area.

A guarantor loan is where someone, typically the borrower’s parents, provides additional security for their home loan which allows them to borrow with no deposit.

Some lenders don’t check the guarantor’s income at all. APRA believes that the guarantor’s income and credit history needs to be checked. I don’t think this is necessary as the guarantor is just providing security. It’s the borrower’s income and credit history that really matters.

ASIC also said that the lenders should manage their exposure or, in other words, not approve too many guarantor loans. They should just be a small part of the lender’s portfolio.

Repaying your home loan using superannuation

APRA stated that a lump sum withdrawal from a borrower’s superannuation account should not be relied upon to repay the home loan. That’s a problem for over 50s because many of them plan to pay off their loan when they retire using their super.

It’s possible that banks that allow people to use this as an exit strategy will soon remove this policy. If so, many older people will not be able to buy a home or will be stuck with whichever home loan they have now as they will be unable to refinance.

Exceptions to bank criteria

Banks don’t always stick to their lending criteria. If there is a good reason to do so then they often make an exception. Nobody ticks all the boxes!

APRA wants banks to report on the exceptions that they make and monitor to make sure their credit managers are managing the risk of their new mortgages well. In particular, banks should look for trends with particular overrides and make it clear to their staff if this is a ‘hard policy’ that should never be overridden or a ‘soft policy’ where exceptions can be made, according to ASIC‘s draft guidance.

APRA wants banks to report on why overrides were made particularly if their scorecard was overridden i.e. the loan failed their credit score.

Security for the home loan

Banks have been very creative with the way that they value properties. APRA has stipulated that it is acceptable for banks to rely on the contract of sale, a desktop valuation (AVM) or a kerbside assessment instead of a full bank valuation.

However, one thing hasn’t change: APRA, like everybody else, doesn’t trusts developers! APRA has suggested that they do not rely on a developer’s valuation and that the lender should subtract any developer discounts or incentives from the purchase price when calculating the LVR.

Properties that have a mixed residential and commercial use should be assessed as commercial for the way that the banks fund their loans. In other words, soon it may be that banks refuse to offer home loan interest rates for these borrowers looking to purchase these types of properties as their cost of funds is higher. This also includes developers who are buying residential properties for development purposes.

APRA want lenders to take lower risks if property values are rising fast. In particular, the regulator wants lenders to limit their high LVR loans to prevent speculative purchases and housing bubbles.

Ultimately, APRA doesn’t want banks to rely on a low LVR or rising property prices to get away with lax lending standards.

Broker remuneration

APRA has noticed that managers within the banks and mortgage brokers tend to bring in and approve better quality home loans when they are paid for long term results. In other words, paying brokers a trailing commission gets a better result than just paying an upfront commission.

There’s no doubt that some mortgage brokers put low quality customers with a few select lenders that do not pay trailing commissions. The current model where most lenders pay an upfront and trailing commission seems to work quite well to incentivise prudent lending practices.

Capital requirements

APRA has suggested that banks shouldn’t use dynamic LVRs to calculate their capital adequacy requirements. In other words, if a loan was approved at 95% LVR and in a couple of years the property had increased in value and the loan is at 80% LVR now then the lender should still set aside capital as if the LVR was at 95%.

That means that 95% loans will cost the banks more to fund in the long term. There might even be an incentive for them to internally refinance these loans when their LVR has reduced.

APRA also suggested that banks should set aside more capital for reverse mortgages as the risk is higher for these loans.

Overall verdict

It’s good to see APRA is keeping a close eye on what the banks are doing but they’re shutting the gate after the horse has bolted.

The way the banks are currently lending is just fine. APRA needs to consider that people need to borrow money and that the banks should be given the flexibility to give people what they want.

We don’t have a problem in Australia and even with a major economic correction our banking system would be just fine. So as long as the banks prudently manage their lending then the regulator should leave them alone.

Keep in mind that non-bank lenders aren’t affected by APRA changes. So Australians will still be able to get mortgages approved that don’t meet APRA’s requirements.

You can read APRA’s draft guide and make up your own mind.