Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 67

Taking the heat out of home lending

The APRA Draft Prudential Practice Guide 223 Residential Mortgage Lending released last month is long on motherhood statements but short on specifics. This is somewhat understandable in an environment where the banks are lobbying aggressively for as few risk restrictions as possible on their businesses when overall credit growth has been sluggish. However, the lessons learnt by other countries during the financial crisis are being ignored by many in Australia, with the predominant view being that since Australia escaped largely unscathed in the last decade it is immune from credit problems in the years to come.

A number of key measures indicate that Australian house prices are at elevated levels, with Australian cities routinely coming near the bottom of global affordability rankings. The combination of low unemployment and very low interest rates means that the pool of potential buyers has increased over the last two years. At the same time as economic factors have favoured borrowers, banks have eased their lending criteria with APRA publicly noting its concerns. Together these changes have allowed potential borrowers to qualify with smaller deposits and/or lower income levels, or to borrow more than they previously would have been able to. Should unemployment or interest rates increase materially, or if tax changes reduce the availability of negative gearing or increase land taxes, a reversion of house prices is eminently possible. There is clearly an increased heat level in the Australian home lending market.

As a guide to what action APRA and banks should be taking now, specific limits are proposed below on key loan characteristics. Potential borrowers should also note these recommendations, as banks may seek to maximise the amount they lend rather than suggesting a lower amount that may be in the customer’s best interests.

Loan to value ratios (LVRs)

LVRs measure how much debt and equity a borrower has in a property. Australian and international default studies have found a very high correlation between high LVR loans (those with low equity) and high default rates. Low levels of equity leave little or no room for periods of greatly reduced income levels such as unemployment or maternity leave. LVRs for bank loans should therefore be capped at 90%, with borrowers required to raise at least 10% of the purchase price as well as covering the cost of stamp duty and lenders mortgage insurance.

Second lien (or second mortgage) loans

Default studies in the United States have shown that loans with second liens default at a much higher rate than loans without. Whilst having multiple layers of debt secured against residential property is rare in Australia, if the maximum LVR is reduced the demand for second lien debt may increase. Australian banks should be limited to offering first lien loans, with no allowance for second liens on properties securing bank loans.

Affordability tests

For many years, common industry practice has been to test the ability of borrowers to meet their repayments assuming interest rates rise by 2% from current levels. With home loan rates now at record lows, banks should increase this test to 3%. This increased stress test implies a movement in the RBA cash rate from the current level of 2.50% to 5.50%, which would be approximately in line with the average of the cash rate over the last 20 years. Banks that use a standardised measure such as the Henderson Poverty Index for living expenses should also be required to have a buffer of at least 10% in their servicing calculations. Many potential borrowers are unlikely to live on such a meagre existence, particularly higher income earners who are disproportionately represented in new lending. Affordability tests should also be based on amortisation of the loan over no more than 25 years.

Interest only loans

Interest only loans are most common with investors, with owner occupiers typically making principal and interest repayments. The lack of amortisation increases the risk of these loans, particularly if interest rates should rise materially without a similar increase in rental yields. To counter this risk, interest only loans should be limited to 80% LVR and for a maximum of five years.

Loan tenor

Long dated loans mean that borrowers make very little headway in reducing their principal in their first few years. They can also be an indicator that borrowers are stretching to make the minimum repayments. Banks should be allowed to offer loan tenors to a maximum of 25 years, with interest only loans limited to five years followed by a 20 year amortisation period.

Lenders mortgage insurance (LMI)

The international experience with LMI is chequered, with poor outcomes in the United States during the global financial crisis and in the United Kingdom in the 1990’s. However, many banks in Australia see the risk of loss on insured loans as minimal. The international experience indicates that during a time when claims are most likely to be made and the insurance is most vital, (when a substantial and sustained increase in unemployment is accompanied by falling house prices) LMI providers may not be able to meet all claims in a timely fashion. To take into account this risk, banks should not be able to treat high LVR insured loans the same as low LVR uninsured loans.

Capital weights

The introduction of Basel III capital weights has seen the major Australian banks holding lower levels of capital against home loans at a time when house prices are arguably most elevated. A tiered system should be introduced that recognises the lower risk attached to low LVR loans and that also provides some credit to insurance from well capitalised LMI providers. Uninsured loans at or below 70% LVR and insured loans at or below 80% LVR could continue to receive the highly discounted risk weighting allowed by Basel III. Uninsured loans of 70-80% and insured loans of 80-85% should be subject to a 50% risk weighting. All other loans should be subject to a full risk weighting. It is acknowledged that such a change would likely result in tiered interest rates to borrowers. This would be a positive development with lower risk borrowers rewarded with a lower interest rate.

Conclusion

In the provision of credit, bad outcomes are not evenly spread with marginal borrowers being a disproportionately large source of impairments and losses. The combination of the current economic environment and easing of lending criteria has brought substantial heat to the Australian home lending market with a greater number of marginal borrowers obtaining finance from banks. The elevated risk posed by these borrowers is added to the systemic risks of Australian banks with their highly leveraged business models and strong dependence on overseas funding. By introducing specific measures aimed at limiting high risk home lending now, APRA would be able to substantially lower the risk profile of Australian banks in advance of a potential reversion in house prices.

 

Jonathan Rochford is a Portfolio Manager at Narrow Road Capital. Narrow Road Capital advises on and invests in various credit securities including those issued by banks.

 


 

Leave a Comment:

RELATED ARTICLES

RBA switched rate priority on house prices versus jobs

Is it time for an Australian 30-year fixed rate mortgage?

It's coming: 10 ways to cool rampant housing prices

banner

Most viewed in recent weeks

Finding the best income-yielding assets

With fixed term deposit rates declining and bank hybrids being phased out, what are the best options for investors seeking income? This goes through the choices, and the opportunities and risks involved.

What history reveals about market corrections and crashes

The S&P 500's recent correction raises concerns about a bear market. History shows corrections are driven by high rates, unemployment, or global shocks, and that there's reason for optimism for nervous investors today. 

Howard Marks: the investing game has changed

The famed investor says the rapid switch from globalisation to trade wars is the biggest upheaval in the investing environment since World War Two. And a new world requires a different investment approach.

Welcome to Firstlinks Edition 605 with weekend update

Trump's tariffs and China's retaliatory strike have sent the Nasdaq into a bear market with the S&P 500 not far behind. What are the implications for the economy and markets, and what should investors do now? 

  • 3 April 2025

Designing a life, with money to spare

Are you living your life by default or by design? It strikes me that many people are doing the former and living according to others’ expectations of them, leading to poor choices including with their finances.

World's largest asset manager wants to revolutionise your portfolio

Larry Fink is one of the smartest people in the finance industry. In his latest shareholder letter, the Blackrock CEO outlines his quest to become the biggest player in private assets and upend investor portfolios.

Latest Updates

Investment strategies

An enlightened dividend path

While many chase high yields, true investment power lies in companies that steadily grow dividends. This strategy, rooted in patience and discipline, quietly compounds wealth and anchors investors through market turbulence.

Investment strategies

Don't let Trump derail your wealth creation plans

If you want to build wealth over the long-term, trying to guess the stock market's next move is generally a bad idea. In a month where this might be more tempting than ever, here is what you should focus on instead.

Economics

Pros and cons of Labor's home batteries scheme

Labor has announced a $2.3 billion Cheaper Home Batteries Program, aimed at slashing the cost of home batteries. The goal is to turbocharge battery uptake, though practical difficulties may prevent that happening.

Investment strategies

Will China's EV boom end in tears?

China's EV dominance is reshaping global auto markets - but with soaring tariffs, overcapacity, and rising scrutiny, the industry’s meteoric rise may face a turbulent road ahead. Can China maintain its lead - or will it stall?

Investment strategies

REITs: a haven in a Trumpian world?

Equity markets have been lashed by Trump's tariff policies, yet REITs have outperformed. Not only are they largely unaffected by tariffs, but they offer a unique combination of growth, sound fundamentals, and value.

Shares

Why Europe is back on the global investor map

European equities are surging ahead of the U.S this year, driven by strong earnings, undervaluation, and fiscal stimulus. With quality founder-led firms and a strengthening Euro, Europe may be the next global investment hotspot.

Chalmers' disingenuous budget claims

The Treasurer often touts a $207 billion improvement in Australia's financial position. A deeper look at the numbers reveals something less impressive, caused far more by commodity price surprises than policy.

Fixed interest

Duration: Friend or foe in a defensive allocation?

Duration is back. After years in the doghouse, shifting markets and higher yields are restoring its role as a reliable diversifier and income source - offering defensive strength in today’s uncertain environment.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.