The Australian Prudential Regulation Authority (APRA) has announced a possible revision to its 7 per cent ‘stress test’ buffer on home loans.
In a letter issued to authorised deposit-taking institutions (ADIs), APRA has proposed removing its guidance and allowing ADIs to review and set their own minimum interest rate floor for use in serviceability assessments.
In the letter, the regulator also proposed ADIs’ serviceability assessments incorporate an interest rate buffer of 2.5 per cent.
APRA’s 7 per cent buffer was first introduced in December 2014 in an effort to reinforce sound residential lending standards.
In particular, the interest rate floor and buffer served to limit excessive borrowing in an environment of low interest rates and high household debt.
The guidance was subsequently incorporated into Prudential Practice Guide APG 223 Residential Mortgage Lending, which APRA is now proposing to amend.
APRA Chair Wayne Byres said the operating environment for ADIs had evolved since 2014, prompting APRA to review the ongoing appropriateness of the current guidance.
“APRA introduced this guidance as part of a suite of measures designed to reinforce sound residential lending standards at a time of heightened risk,” Mr Byres said.
“Although many of those risk factors remain – high house prices, low-interest rates, high household debt, and subdued income growth – two more recent developments have led us to review the appropriateness of the interest rate floor.”.
The changes, while likely to increase the maximum borrowing capacity for a given borrower, are not intended to signify any lessening in the importance that APRA places on the maintenance of sound lending standards.
Mr Byres said with interest rates at record lows and likely to remain there for some time, the gap between the 7 per cent floor and actual rates paid has become wide in some cases – possibly unnecessarily.
“The changes, while likely to increase the maximum borrowing capacity for a given borrower, are not intended to signify any lessening in the importance that APRA places on the maintenance of sound lending standards.
“Rather, it is simply recognition that the current interest rate environment does not warrant a uniform mandated interest rate floor of 7 per cent across all products.”
According to Mr Byres, the proposed changes will provide ADIs with greater flexibility to set their own serviceability floors, while still maintaining a measure of prudence through the application of an appropriate buffer to reflect the inherent uncertainty in credit assessments.
A four-week consultation will close on 18 June, ahead of APRA releasing a final version of the updated APG 223 shortly afterwards.
According to RiskWise Property Research, the removal of the 7 per cent ‘stress test’ buffer on home loans would see a 9 per cent increase in borrowing capacity for owner-occupiers.
The firm also predicts that number would rise to between 13 and 14 per cent if the Reserve Bank of Australia (RBA) undertakes two interest rate cuts before the year is out.
CEO Doron Peleg said with the current ultra-low interest rate and two interest rate cuts projected by the RBA, APRA’s 7 per cent ‘stress test’ was a major barrier for borrowers in an already highly regulated and scrutinised lending environment.
However, its reduction or removal would mean if the interest rate for owner-occupiers was about 3.75 per cent, they would pay about 6.25 per cent, which would create a 9 per cent borrowing capacity.
“This will be a major boost to the market, especially as now the number one risk has been removed thanks to a Coalition win and the elimination of the threat of taxation changes to negative gearing and capital gains tax.”
Mr Peleg said while the guidance was necessary when it was first implemented in 2014, the approach is now too conservative for the lending landscape of 2019.
“Interest rates are now very low with a very high likelihood of additional cuts by the RBA, and no signs of increases in the foreseeable future,” he said.
Mr Peleg called the low-interest rate environment the ‘new normal’ in Australia.
“Loan applications are heavily scrutinised, lenders are applying more conservative credit policies, the proportion of interest-only loans is now low with only 16 per cent of the new loans (December 2018) being interest-only and 7 per cent of loans at 90 per cent.”
RiskWise Property Research analysis showed a reduction of at least 1 per cent was needed in order to have some meaningful impact.
This is equivalent of the APRA’s announced change, that, while taking a different approach, will put the effective floor assessment at 6.25 per cent for owner-occupiers in the current lending market.
The research group recently undertook a case study of a scenario involving a married couple, who both receive average weekly earnings at their full-time jobs, and have two children.
The couple require a loan of 30 years and their only expenses are either Household Expenditure Method (HEM) or HEM X 1.5, with the assumption they had no credit card repayments and other expenses.
“Our analysis showed that due to the scrutinising of loan applications and by applying the effective 7.25% ‘stress test’ this materially reduced their borrowing capacity by 33 per cent,” Mr Peleg said.
“The borrowing capacity of $698,000, based on the HEM and ‘floor assessment’ of 7.25 per cent, is equivalent to HEM X 1.5, with an interest rate of 2.87 per cent.
“As a result, the couple would have to totally re-assess their entire purchasing strategy.
Mr Peleg said APRA’s change is equivalent to the required reduction in the floor assessment that has the right balance between having a meaningful impact, while still having good risk-management practices.
The REIQ welcomed APRA’s proposal to remove the quantitative guidance on the level of the serviceability floor rate, allowing lenders to set their own floor rate.
REIQ CEO Antonia Mercorella said this could mean a significant difference for many first home buyers trying to get into the market.
“We know that buyers are trying to get into the market but have been falling short of the 7 per cent or 7.25 per cent serviceability rate set by APRA and enforced by lenders,” she said.
Ms Mercorella said the consistent feedback they received from agents indicated a rising number of contracts had been falling over at the finance stage, largely because of serviceability assessments.
“In the post-Inquiry climate, the perception in the community is that it’s very difficult to borrow for a property. This proposed change will give lenders an opportunity to reassess lending assessment criteria and, potentially, give more loans,” Ms Mercorella said.
“Just as the real estate market benefits from greater confidence, so, too, does the finance sector and it’s crucial that banks work to re-build that trust.”
Financial comparison site RateCity.com.au have welcomed APRA’s proposal, speculating that for many first home buyers it may give a significant boost to their borrowing power.
RateCity.com.au analysis has shown a family on an average household income of $109,688 would be able to borrow up to around $60,000 more if their loan was assessed at 6.25 per cent instead of 7.25 per cent.
The average single person would be able to borrow up to around $50,000 more under the same scenario.
RateCity.com.au Research Director Sally Tindall said the change could be more effective than an RBA rate cut for new borrowers.
“This is going to be a game changer for a lot of potential buyers who can’t quite get their home loan application across the line.”
Ms Tindall said, while the RBA hinted at an impending rate cut, this potential change could buy them some more time, despite the fact that it won’t affect families with existing mortgages.
“After a record-breaking 33 months of living with a cash rate at an historic low, the new norm for interest rates has changed dramatically,” she said.
“On top of this, we’ve just lived through two years of intense scrutiny from the regulator and the Royal Commission, so the hoops people have to jump through to get the green light on a loan are onerous – perhaps overly so.”
Ms Tindall said the proposal strikes a sensible balance where prudent lending still remains front of mind for both borrowers and lenders.
Investment research house SQM Research has also welcomed APRA’s proposal to loosen present day lending restrictions, placing more responsibility on the banks to determine their own limits.
Owner Louis Christopher speculates the move could mean more loan applicants will qualify for a loan and/or their borrowing limits will increase.
SQM Research initially believed today’s move by APRA was part of a strategic decision by the RBA to loosen
credit restriction instead of relying on a further easing in monetary policy to stimulate housing.
However, after the most recent statement released by the Reserve Bank, they predict a cut in the cash rate next month to be almost a certainty.