Out Of Touch
The tests banks apply to mortgages need to be scrutinised and updated, writes John Bolton.
1 September 2019
Many baby boomer investors aren’t planning or thinking about how to manage their properties as they transition into retirement. Not so long ago, you could wing it a little, but new banking policy has made that difficult. If you don’t plan your retirement, you risk getting caught out.
Old Game, New Rules
The Royal Commission in Australia highlighted poor behaviour in banks and put a blowtorch under how banks apply the responsible lending code.
Banks have been dumbing down staff as part of building very economic and vastly profitable franchises. Expenseto- income ratios of around 40% would be considered impossible in almost any other industry, even noting that banks have an additional cost around the amount of capital they must hold.
No matter how you look at it, banks have become very efficient.
The old days of getting a loan from your bank manager disappeared decades ago. Bankers are simply not skilled or trusted enough and credit managers are now too nervous to put any judgment across their decisions. Banking has become very rules-based, driven by policy that although robust, is typically blunt. Some questionable policy areas include:
- The test rates banks use
- The amortisation term banks apply to loans
- Banks’ (sometimes daft) responses to things like interest-only
- The now absolute rule that a borrower must be capable of servicing their loan based on hypothetical models, irrespective of their future intentions. The policy rules that banks apply are not sophisticated – and therein lies the risk. A risk that, for investors going into retirement, is potentially serious.
Happy Lenders Unhappy Investors?
The crux of the risk sits with how banks discharge a property as security when it’s sold.
If an investor has multiple properties with one lender, and one of those properties is sold, the lender controls the discharge of the property. The investor might be selling a property they consider to be debt-free that is cross-collateralised with another property. However, the bank will see it differently. It will look at the investor’s overall portfolio and affordability and could request the full sales proceeds.
Maybe that is ok, but chances are the property investor intended to free-up cash for something else. The lender is happy. They have been repaid. But what about the borrower?
How Banks Calculate Affordability
Why do banks behave this way and what does it mean for near-retirees?
To understand this, we need to work through how banks calculate affordability. Some of this won’t make sense – but that’s my point. A property investor could have a loan-to-value ratio of 50% on their investments and a debt-free house, but affordability will still be assessed based on an interest rate of 7.5% and amortisation over 30 years.
It doesn’t matter that the investor intends to sell a property or two in a few years and would be debt free. It also doesn’t matter that the actual loan will be on interest-only and on a three-year fixed rate of 3.89%. The property is still assessed at 7.5% and on principal and interest repayments.
Reality V Hypothesis
On a one-million-dollar loan, the bank will test the investor’s affordability against a monthly repayment of $7,000 per month, versus actual repayments using the scenario above of $3,240 per month. That’s an over 50% difference between hypothesis and reality.
I encounter lots of baby boomers making decisions based on the reality without factoring that the bank is using a completely different calculator.
The next challenge is that typically lenders will only allow for 75% of rent income. If we assume a 4% yield and that $1 million of lending is on a $2.5 million property, then the monthly income after deducting 25% is $6,250 per month.
In reality, the investor in the above scenario has about $3,000 per month positive cash flow but the bank assesses them as having $750 per month of negative cash flow. Next month’s column will examine these issues further and look at the hurdles pensioners face drawing down a mortgage.