‘Meaningful’ serviceability tests are becoming ever more crucial for mortgage originators wanting to maintain the high quality of their portfolios as interest rates reach historic lows, according to Fitch Ratings director, David Carroll.
In a newly-released report, Carroll says Australia’s current low interest rates, coupled with high house prices and household leverage, could expose borrowers to future payment shocks when interest rates rise.
“It is therefore important that residential mortgage lenders factor into tests rates that are closer to historical averages, so that borrowers, particularly first-time borrowers, are able to service their loan obligations should interest rates return to average historical levels or higher.”
At loan origination, lenders typically stress borrowers' serviceability using a buffer of 1.5 to 2.0 percentage points higher than existing rates. Most lenders, including the four major Australian banks, also use a minimum lending rate in their borrower serviceability calculations to help guard against payment shocks.
Therefore, Carroll says this isn’t a major concern - but it does need to be monitored.
“A minimum lending rate can capture the risk that rates return to average historical levels that are higher than the stress rate with the addition of a buffer. This has been demonstrated in previous periods of low interest rates in Australia.”
Average residential mortgage standard variable interest rates (SVR) at the large banks that provide the bulk of Australian mortgage lending are currently 6.1%, with borrowers usually able to get discounts of 0.5 to 1.0 percentage point. SVRs have been as high as 9.6% as recently as September 2008.
For example, according to Fitch Ratings, monthly loan payments would rise to AUD2,544 from AUD1,820 for a home loan of AUD300,000 should rates return to recent SVR highs. This 40% increase could severely reduce a borrower's ability to meet their mortgage obligations.
Unemployment, which is a key variable in driving mortgage performance in Australia, is projected to rise to 6.3% in 2014 from 5.7%. An interest rates rise, together with the projected rise in unemployment, could adversely impact borrowers and residential mortgage vintages originated in a low interest rate environment.
The RBA cut the cash rate by 25bp to 2.5% at its August meeting. Eight cash-rate cuts, totalling 225bp since October 2011 and the average 1.8 percentage point reduction in the SVR from the major banks, have had a marginal and diminishing impact on existing mortgage performance.