The latest Financial Stability Report from the Reserve Bank carries a stark warning about the risk of over-leveraged mortgage holders to the economy.
Deputy Governor Geoff Bascand noted the high levels of activity in the housing market had led to an increase in higher-risk lending, particularly among property investors.
“High leverage in the housing sector poses risks if house prices fall sharply or unemployment rises, reducing the ability to service loans,” Bascand said.
“This is why the Reserve Bank intends to re-impose LVR restrictions to guard against continued growth in high-risk lending and ensure that banks remain resilient to a future housing market downturn,” Bascand said.
The Reserve Bank has signalled it intends to consult on re-introducing the bank restriction from March 1, and a number of banks have already reinstated LVRs for property investors.
In the meantime, however, many current homeowners, tied to huge mortgages, are exposed to massive risks of job instability and rising interest rates.
So how do you know if you’re over-leveraged, and what can you do to avoid the worst?
Tom Hartmann, the personal finance lead at the Commission for Financial Capability, tells the Herald risk always comes into play when taking on a huge mortgage.
“While the lender can adjust pricing to cover their risk, the borrower is left to shoulder any future risks that come with a change of circumstances,” Hartmann says.
“These often can emerge because of a drop in income, or a shift in interest rates. Either can result in someone being over-extended with their borrowing.”
Hartmann suggests conducting a simple stress test to gauge the severity of the impact should your circumstances change.
“Where would repayments result if the interest rate jumped three percentage points, for example?” says Hartmann
“Interest rates are bottoming out now, but a mortgage is a multi-decade affair, and rates will change eventually.”
Banks actually test people’s ability to service a loan at a rate that is much higher than the advertised home loan rates. Reserve Bank figures show the average test servicing rate was 6.4 per cent in September, down from 7 per cent a year earlier.
But the advantage of low interest rates can coax homeowners into a false sense of security about their financial stability.
Another stress test suggested by Hartmann is questioning what might happen if your income was affected – as many were over the course of the last year.
“Would you find it difficult to make repayments should your income drop, or for example if your household went down to one income for a time? If so, you may be over leveraged.”
Hartmann recommends creating an emergency fund to ensure you don’t fall behind on payments if things go awry.
“We recommend a starter safety net of $1000 to get people started saving, but a more fully funded emergency fund would be to have three months’ worth of expenses at the ready in case one’s income is interrupted,” he says.
“Depending on what type of work a person does, they may need even more months of expenses set aside to bridge until they get back on their feet earning.”
Taking a longer-term approach can also be an effective strategy to gnawing away at the massive burden of mortgage that stretches into hundreds of thousands of dollars.
“Ideally, all mortgage holders would be making repayments that are above the minimum amount required,” Hartmann says.
“Each dollar above that amount helps the borrower save on interest costs and basically structures the mortgage more in their favour. As our Sorted mortgage calculator shows, this can save thousands, perhaps even tens of thousands in interest over time.”
Paying above the minimum also gives you the leeway to adjust repayments should your financial position or stability worsen.
“Not being able to repay above the minimum can be taken as a sign of being over leveraged, you could say,” says Hartmann.
“With every dollar going to the minimum, it can be a disaster when things go awry as you point out.”
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