As the saying goes, if you’re standing still you’re in fact going backwards, and this is just as relevant for our economy. Change is necessary for our economy to survive and thrive! Change also brings opportunity, and therefore being aware of the changes enables you to take advantage of the new rules, or at least it enables you to build a war chest to ensure your financial position continues to prosper over the long term.
What is happening and why?
After warning of “heightened levels of risk” in the housing market, APRA has pulled out the big stick and ordered the big banks to increase the amount of capital they are required to hold against their residential mortgage exposures. In essence this means that ANZ, Commonwealth Bank, National Australia Bank, Westpac and Macquarie will have to retain billions of dollars that would have otherwise gone out in home loans. The result of this is reduced mortgage lending volumes and therefore more expensive mortgages.
The big five banks currently count their loan exposure on a 16% risk-weighting, and are required to hold 8% capital (equity) against the risk-weighting. As of 1 July 2016 this will rise to 25% risk-weighting, with 10% capital (equity) required to be held against the risk-weighting.
To illustrate what this means, let’s look at a $1million loan. At a risk-weight of 16%, the bank could count the loan exposure as $160k (16%) and therefore they are required to hold 8% of the loan exposure amount in capital, which equates to $12.8k (i.e. $1million x 16% risk-weighting = $160k x 8% capital required = $12.8k equity to be held).
The change in the risk-weight to 25% and the increased capital required to 10% means the bank will be required to hold $25k for the same $1million loan (i.e. $1million x 25% risk-weighting = $250k x 10% capital required = $25k equity to be held).
That’s an increase of 95% of additional capital (equity) the bank must hold for a rainy day! (i.e. from $12.8k to $25k), almost double the amount!
How does this effect the bank and why should you care?
Assuming the bank makes 50 basis points on a $1million loan, that equates to 39% return on equity (i.e. $5k profit on $1million lending divided by $12.8k). As of 1 July 2016, the return on equity reduces significantly to 20% (i.e. $5k profit on $1million lending divided by $25k) and therefore the bank must increase its loan profit margin by almost 50 basis points to maintain the same return on equity.
Banks are in business to make money and to deliver a satisfactory return on equity to their shareholders. These changes (in response to APRAs ruling) will force banks to pass on the increased cost to their home loan customers, otherwise they need to find a way to reduce their expenses. I suspect it will be combination of both!
There are FOUR key areas of change occurring right now which you should be aware of
- Interest rates for investor loans are increasing
- LVRs are being restricted for investor loans
- Serviceability assessment is more stringent
- Off the plan buyers may be in for a shock when settlement date arrives
FIRST, investor mortgage rates are on the way up. The following changes have been announced and come into play in the next week or so…
- ANZ, Commonwealth Bank and Macquarie Bank have increased the variable rate for investment loans for new and existing customers by 0.27%
- National Australia Bank have increased the variable rate for Interest Only loans for new and existing customers by 0.29%
- AMP have increased variable rate for existing investment loans by 0.47%
Westpac and Bank of Melbourne at this point have remained quite, but I suspect its a matter of days before they follow their peers.
AMP announced today (29th July 2015) that they have pulled out of investment lending until further notice, expected to be until at least the end of 2015.
SECOND, LVRs have been restricted for investor loans. The following changes have been announced…
- Westpac, Bank of Melbourne, St George Bank, and Bankwest will now only lend up to 80% LVR for investor lending which means you will need a 20% deposit (plus costs) for an investment property purchase
- For SMSF loans, St George Bank and Bank of Melbourne have announced a reduced LVR to 70%; previously this was 80%
THIRD, borrowing money for investment purposes will be more challenging as some banks announced policy changes for serviceability purposes.
Most banks now require you to service the new debt and your existing debts (commitments) at 7%+, which includes at least a 2% buffer. Previously banks would treat your existing commitments on actual repayments and not load the interest rate.
ANZ have removed the cash flow benefit of negative gearing and Commonwealth Bank and Westpac have reduced the rental income received from an investment property significantly, which means the bank wants to rely more on your working income as opposed to the cash flows from your investment properties.
FOURTH, off the plan purchases have become even more risky all of a sudden. The main reason being that it’s too hard to predict what other changes will be announced. If the goal posts change between now and settlement, then you could be stuck and unable to raise the finance to complete the transaction at settlement.
For example, if you qualify right now for an 80% LVR loan for an off the plan investment property purchase and the bank announces a maximum LVR of say 60% for an off the plan purchase, then you’ll have to find the additional 20% to meet your settlement commitment.
A pre-approval today will be worthless in the future as pre-approvals have a three-month shelf life!
Further, the bank will value the property towards completion and if the market changes (e.g. property values taper off) and the bank valuation differs to the actual purchase price, then you’ll need to find the extra cash to bridge the gap.
In summary, these recent lending policy changes are a game changer for investors. Banks have tightened the screws on investors in a significant way. The beneficiary of these changes are likely to be first home buyers and upgraders (both home owners) as banks will make numerous special offers to maintain home loan volumes and protect their profits.