RBA on what's posing a risk to borrowers

High debt-to-income loans on rise, study reveals

RBA on what's posing a risk to borrowers

Rising interest rates and potential falling house prices pose a risk to certain borrowers, the Reserve Bank of Australia Financial Stability Review for April shows.

The share of new high debt-to-income ratio mortgage lending (DTI of six or more) “increased significantly” to 24% in the December 2021 quarter, the RBA said.

In line with a rise in lending to first home buyers over 2020, the share of new high loan-to-valuation ratio loans (LVR 90 or above) increased but had since reduced.

Although near term financial stability risks arising from the COVID-19 pandemic had eased, a “small share of borrowers” remained vulnerable to falling cash flow, the RBA said in the report. This included households that were both “highly indebted” and had “low excess payment buffers” available to use.

Most households and businesses were “well-placed” to absorb higher debt repayments as interest rates increase, RBA said. But if rising inflation wasn’t accompanied by faster household income growth and rising business profitability, there were risks around borrowers’ capacity to repay.

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“Looking further ahead, medium-term systemic risks remain elevated and so it is critical that lending standards remain strong,” the RBA said in the report. “Although the vast majority of households are well placed to repay their debt, the aggregate household debt-to-income (DTI) ratio has edged higher, and the increased share of new housing loans with a high DTI ratio indicates that some new loans could be relatively risky.”

A recent increase in the interest rate buffer APRA expected lenders to use in their loan serviceability assessments would have “reduced the supply of credit” to new borrowers most at-risk of running into difficulty, the Reserve Bank said.

“It is important that lending standards do not slip and that borrowing, and lending decisions are resilient to higher interest rates and the potential for falls in housing prices and/or real incomes,” the central bank said.

Discussing the degree of risk in high DTI and high LVR lending, the RBA said increased mortgage stress among high LVR and high DTI borrowers could be due to the high ratios – but could also be due to other characteristics that made their loans riskier. Risks could change at different points in the economic cycle.

 “For a given borrower, a high LVR or high DTI loan will be riskier for the lender.  All else equal, having a higher DTI - and so higher repayments relative to income - makes it more likely that a borrower who experiences an adverse shock to their income or expenses will miss mortgage payments,” the report said.

In the event of a cash flow shock, high DTI borrowers were more likely to need to reduce their consumption (spending). There was an increased likelihood borrowers with high LVR loans may also run into difficulty, as lower equity made it harder to sell the property or refinance the loan.

Atelier Wealth managing director and founder and MFAA-approved broker Aaron Christie-David (pictured) said a low LVR borrower could still have a high DTI ratio, meaning they weren’t totally immune to serviceability risks.

For example, a borrower could have bought in an area where prices had since skyrocketed, yet their income relative to mortgage payments remained high.

“If it’s a combination of high DTI, high LVR, that could possibly be a high risk but I think if they’re one or the other, there are mitigants around it,” Christie-David said.

As banks already had DTI ratios in place and not all banks lend to high DTI borrowers, he disagreed that overall, high DTI loans were riskier for the lender.  

“These loans are restricted to 5.5%, 6%, so even if we get rates that are increasing, these households have already been tested at higher serviceability rates,” he said.

Bank stress testing meant borrowers had the capacity to accommodate higher living costs.

Christie-David also pointed out that all borrowers, including high DTI and LVR borrowers, could potentially be exposed to a sudden bill shock or other unexpected event, which couldn’t be captured on a loan application or servicing calculator. 

Although it fell outside of a broker’s role, Christie-David said brokers could talk to clients about upcoming lifestyle factors that required them to keep a reasonable buffer in cash savings.

Alternatively, brokers could talk to their high DTI and high LVR clients a few months after their house settled. But once the loan had been arranged, managing defaults on loan payments, including any risks of doing so, was the borrower’s responsibility, he said.

“More often than not, it’s been a cash flow issue, or it’s a changed direct debit, or their employer pay … the general rule of thumb would be that something’s come up and a ‘bill shock’ is when most people have that missed payment,” Christie-David said.

“Where it goes a bit deeper, I feel it’s probably that employment or income issue, but in my opinion, I’d say it’s a borrower’s responsibility.”

Bank Australia national manager partnerships Vincent Lewis said as a conservative lender, the bank builds buffers into its home loan calculator that can restrict maximum borrowings customers can access.

“For high LVRs of 95% plus, and DTIs over five, we apply additional discretionary income requirements which help mitigate possible hardship,” Lewis said.

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Irrespective of whether they were high LVR and/or high DTI borrowers, the bank’s key message for borrowers in trouble was to let the bank know as quickly as possible.

For loans sold through brokers, it was preferable that the customer contact the bank directly.

“This mitigates any privacy issues, however, we will engage with broker to inform them of developments,” Lewis said.

By recommending the right loan for a client’s needs – something brokers were already mindful of and practising – they could prevent clients from overextending themselves, he said.