Australian Investor Loans: How Much More Will They Cost?

rate delta

You don’t need to look far to see that property investor loan interest rates have increased significantly above owner-occupier home loans in the last year. Investor loans currently have interest rates 0.3% higher than owner-occupier rates.

Before APRA took initial action to limit year-on-year investor loan growth in 2014, investors and owner-occupiers were paying the same interest rate and with some bank preference to even charge investors less. This is at odds with overseas, where buy-to-let mortgage (investors loan) interest rates are approximately 1% higher per annum.

Part of this Australian market attribute is driven by the perception that investor loans have less risk: if the renter loses their job then you can replace them with someone else. If an owner-occupier loses their job, they might default on the loan. No recessions helps reinforce this.

Wrong Assessment

From my perspective, this is the wrong assessment and overseas banks clearly agree with me – hence the higher interest rate for buy-to-let mortgages.

For owner-occupiers, the 4 Major banks hold approximately 2.5% credit risk capital on home loans (APRA average). When offering home loans at 3.8% they make around a 30% return on regulatory capital.

The 2.5% credit risk capital is driven by the probability of default (PD) and loss given default (LGD). This falls into the ranges of 0.2% to 0.3% for PD and 10% to 25% for LGD. I expect the Major banks are on the aggressive end here.

For investor loans, there is a similar analysis with similar PD and LGD assessment. I also expect that the price increases are more of a supply/demand consideration given that the year-on-year limit is within sight – so there is a little else a bank can do except raise prices.

The Credit Risk Assessment is Potentially Wrong:

Key Question: Should investor loan credit risk be measured by Basel 2’s PD & LGD formula? Possibly not.

The main risk I see in these portfolios is the assumption that new renters will be available rather than the property investors’ ability to service the loan. So the 99% downside financial stress needs to be driven by 2 things:

  1. What will the renter vacancy rate increase to in a 99% downside scenario
  2. If there is rental income contraction, does that influence the likelihood of investor default.

These 2 items should be additive. Note: for credit risk capital we assume a fully diversified portfolio, so can use broad averages.

Renter Vacancy Rate:

As a broad estimate, the vacancy rate could increase by 10%. This will be driven by renters losing their jobs and/or downsizing and/or moving in with others for an interim during a deep recession. Unemployment rates could potentially rise by 10%, so I have mimicked this for the increase in rental vacancy rate.

I make no judgment on in investors themselves lose their jobs – but I would presume this would could to default. I will assume everyone who loses their job is a renter. If a property is not rented out for 6+ months, I assume the investor will default as property price declines will not bail them out (they will be in negative equity, on average). As unemployment rates will rise for more than 6 months, the vacancy and hence default rate will hit the 10% level.

Rental Income:

This one is harder as it is a sensitive supply & demand problem and the serviceability is a 2nd order impact. I will simply assume that there is not impact at this stage.

99% Stressed PD

Based on this, the 1-Year 99% downside Stressed PD (SPD) could be 5%-10%, depending on the increase in jobless rate, with a preference to selecting 10% and assuming a severe stress to the mining or financial sector.

The 10% SPD in this instance is also the stressed PD required for capital calculations. Using this in a loan capital & pricing model, I obtain an investor mortgage rate of 4.4%, which is 0.6% higher than owner-occupier.

Why is the UK 1% higher?

The calibration of loss-given-default might be important. Whilst broad market LGD could be assumed to be 20% (derived from a 35% decline in property prices plus 10% collection costs on an 75% LVR property), specific property investment stressed house prices could be considered to fall much further. If this is in the 50% to 70% range then the LGD is 40%+. If we then revisit our pricing, we can get a difference between owner-occupier and investors to match that 1%.

So What Happens Next?

Australia has a lack of recession-based data, so cannot really make an assessment of investor loan risk based on observed defaults and losses. The main concern is the divergence from countries and banks that have better data sets that have led to higher pricing for higher risk in investor loan markets. This higher pricing is also driven by stricter regulatory intervention which is also derived from a view on risk.

Given the regulatory hurdles in place, increasing risks for high rise apartments and the above analysis, we are forecasting that most Australian banks will have investor loans with interest rates 0.6% higher than equivalent owner-occupier. This is a further 0.3% increase on the current situation. Shame investors didn’t get a FlexiFix loan.

Watch this space!

 

 

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Australia’s Major Problem: The 4 Major Banks Are Stuffed Full

hamster

One key attribute of the Australian financial system that people need to know about is the reliance on the 4 Major Banks to fund the economy. The lack of wholesale markets, driven by local insurance and local superannuation funds desire to invest sub-investment grade credit or equity portfolios (as opposed to investment grade and AAA/AA/A securitisations), has led to a reliance on the 4 Major Banks to fund the economy.

This is most easily seen in the following tables:

Total Assets $AUDm as Per Annual Reports
30/06/04 30/06/05 30/06/15 30/06/16
CBA 305,995 329,035 903,075 933,078
WP 237,036 254,355 812,156 839,202
NAB 411,309 419,588 955,052 777,622
ANZ 259,345 293,185 889,900 914,900
4 Major Total 1,213,685 1,296,163 3,560,183 3,464,802
GDP (past 4 Qs) 1,190,000 1,229,000 1,617,000 1,658,000
As % of GDP 101.99% 105.46% 220.17% 208.97%

 

Lending Liabilities $AUDm As Per Annual Reports
  30/06/04 30/06/05 30/06/15 30/06/16
CBA 205,946 235,849 674,466 700,547
WP 170,863 188,073 623,316 661,926
NAB 247,836 260,053 532,784 510,045
ANZ 204,962 230,952 570,200 575,900
4 Major Total 829,607 914,927 2,400,766 2,448,418
GDP (past 4 Qs) 1,190,000 1,229,000 1,617,000 1,658,000
As % of GDP 69.71% 74.44% 148.47% 147.67%

For the past decade, Major Bank balance sheets (both total assets and total loans) have grown, on average, at 10% CAGR (except NAB, which has been impacted by overseas businesses). These assets and loans are mostly domestic.

At the same time, GDP has grown at 3% CAGR in nominal terms, leading to approximately 7% higher bank balance sheet growth than GDP each year. The 4 Majors used to have total assets/loans at 100%/70% of GDP but now have 220%/148%.

Stuffed!

At what point do the 4 Major Banks get full? How can the economy continue to grow at a strong level if the bank balance sheets can no longer grow credit above GDP growth as either deposit growth struggles to keep up or financial stability reduces given the high concentration risk of funding via such a narrow channel. Can this lead to a credit crunch? My view is that they may already be sufficiently full to prevent new lending at anything close to the rate experienced in the last decade (noting the below trend YoY growth in 2015/2016, albeit with NAB’s Clydsdale disposal making an impact).

Possible Mitigation

As a response, only a few alternative strategies are really available:

  1. Overseas Wholesale
  2. Local Wholesale
  3. Interest Rate Reduction
  4. RBA Funding (QE)

The 4 Major banks need to tactically grow overseas and local wholesale markets. Overseas distribution of securitisations, particularly the US market, has continued to be an available option but banks may need to consider how the pass fully desonsolidated deals into this market and what return requirements they are willing to take to facilitate this. Even if the 4 Major Banks don’t take the bulk of the spoils, the overall support this gives to the wider economy will lead to better outcomes for the 4 Majors. This may require supporting non-ADI Australian lenders, including FinTech, and identifying high-value opportunities in assisting these business. This may also lead to the development of broader local wholesale options.

Local wholesale potential is split between expanding the lending performed by insurance companies – which could be enhanced by regulatory changes – or by encouraging superannuation to take on a higher percentage of fixed income assets in their portfolios, particularly senior tranches of asset-backed securities. The obvious rationale: if super funds don’t support lending in Australia, there will be detrimental impacts to equity returns that make up the majority of their portfolios as net new lending is an input to economic growth.

Screen Shot 2016-11-16 at 13.54.22

An alternative approach will be for the RBA to buy financial assets. If a local securitisation market does expand, this could be supported by a form of QE. This would be inline with actions the US Fed took in buying agency RMBS or the ECB in corporate bonds.

The last option will be lower interest rates that may be linked with QE. Lower interest rates will support further credit growth and help banks manage a higher balance sheet level versus GDP. But note that interest rates are already low for an economy where the banks have mostly been well-run and capitalised.

Something has to happen

Without a system-oriented movement into addressing the runaway growth of the 4 Major Bank balance sheets, I would expect a major debt-driven problem to emerge in Australia within 5 years. This doesn’t imply a crisis at this point in time but does suggest an eventual fall in the rate that the economy can grow. If house price growth has been driven by credit expansion, this trend simply cannot continue without the financial system becoming top-heavy due to the 4 Major Banks’ balance sheets.

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offset ripoff

Offset Home Loan: Is it worth it?

offset ripoff

One of the sacrifices we have to make when building a long-term fixed rate home loan is a reduced ability to add some extra features, such as an offset account to the loan. Whilst we don’t see this as a major issue (which we will show below) it was a sticking point with one bank we  talked to. They told us “the offset account is important in case borrowers want to buy a boat!”.

Seriously.

This drives us to offer value in other areas, with features like no break fees, freedom to repay a fixed loan anytime and a fixed rate for 10 years. These all form part of our key value: borrowers get to fix the interest rate for 10 years but can switch or pay off any amount when they choose. This has a huge amount of value.

The Offset

The history of the offset account is interesting and its use does make sense. Banks started offering offset accounts as a good way to combat non-bank lenders. An offset account, which is a deposit account and you need to be a bank or ADI to offer it, sits there and reduces your home loan exposure. If you have a salary being paid in, then the mortgage interest paid is reduced by the offset. More importantly, any savings you hold in deposit effectively attract the mortgage interest rate and are tax exempt (awesome).

For example (which we also use in our analysis later):

Home Loan Interest Rate = 4.0%

Best bank account savings rate = 2.5%

Tax Rate = 30%

If you didn’t have an offset, you would only save at 2.5% and be due to pay tax on those earnings, lowering the effective post-tax interest rate to 1.75% (2.5% * (1 – 30%)) for a 30% marginal tax rate payer.

Compare this to earning 4.0% with the offset account and looks like a good idea. But this is only a partial view.

Different Approaches

We need to be careful: the borrower could simply just pay off some of the mortgage with those savings and then refinance to release the savings at a later date.

Alternatively, the borrower could invest those savings into other assets and earn a higher return, albeit with some investment risk. Finally, banks may charge higher interest rates to get access to offset accounts.

What we want to know: how much is an offset worth and does it make sense to go for one?

To do this analysis, the impact of the Offset is measured across 2 fields: the Salary Impact and the Savings Impact.

Salary Impact

The first part to this is paying a salary into the offset account at the start of the month to reduce the loan balance. To make things easy, I will simply assume this salary is paid at the start of the month to give the largest possible impact. In practice, we would expect perhaps only 60% of the economic impact due to the loan balance reducing over the month – for example to pay off credit card and other bills.

We looked at 4 sets of households: low and high earners (in household terms) and each using an offset or not.

Household Household Income Mortgage Offset Account Estimated CPR Tax Rate
Low Earnings with Offset $60,000 300,000 YES 15% 25%
Low Earnings $60,000 300,000 NO 15% 25%
High Earnings with Offset $150,000 900,000 YES 15% 35%
High Earnings $150,000 900,000 NO 15% 35%

In addition, we also assume the non-offset household puts their salary into a savings account (at 2.5%) but pay tax on the interest earned.

To make a comparison, we reduce the interest rate of the non-offset household until the interest payments between the offset and non-offset households are essentially equal.

What we observe in these cases is the net benefit to the offset households is approximately 0.05% (5bps). If just savings methodology are applied, a household is 0.05% better off, each year, by using an offset account.

[To estimate this, consider $4000 paid in each month in salary. This equates to lowering the loan balance by $4000 for the life of the loan and saving 2.25% on that balance (4.0% minus 1.75%).  Assuming $300,000 loan balance, this is a $90 saving per year on $300,000 = 0.03%. We used a more complex model that considered inflation to assess the impact, hence the higher value of 0.05%.]

CPR made little impact over observable ranges.

If we assume only 60% of the economic impact, the annual economic impact is reduced to around 0.03%.

Savings Impact

The secondary impact is how savings influence the borrower and note that this is additional to the Salary Impact.

Assessment is harder as households could invest savings into non-cash assets. Cash in bank accounts is typically low earning as it is deemed to have very low risk whereas stocks and shares have higher risk but higher returns (and average to about 4-6% higher per year). Property has also increased significantly recently: should a borrower have savings or an investment property.

For our assessment, we will simply assume the borrower has savings in cash. For the offset account, there is a single approach as the mortgage balance reduces and the savings earn 4.0% without any tax implications (as 4% is the mortgage interest rate).

The non-offset borrow has 2 approaches:

  1. Pay off the mortgage and then redraw or refinance at a later stage as required
  2. Keep the savings in a separate account, get a lower interest rate (2.5%) and pay tax on the earnings

Within this, there are a few things to note. Paying off the mortgage is a good use of money if you have no desire to take additional investment risk in the short to medium term. If you do need to get access to the higher equity balance in your property, refinancing usually costs about $1500. You might get a free redraw access from some lenders (if you are not changing lender, the costs will be lower), so looking for redraw rather than offset is another option.

Keeping a separate savings account only makes sense if you want access to that money in the short term – notably within 2 years.

Combining the 2, if you know your approach, then we can find a maximum impact from not having an offset. If you need complete flexibility in the savings then there could be a far higher cost which we can then assess but do note: wanting full access and flexibility but not knowing how or when you will use it is possibly a poor approach – similar to leaving a large cash balance in your checking account.

Pay-off Mortgage and Re-Draw

The cost of this approach is based upon how often you re-draw/refinance and what the loan balance is. We assume each redraw $1500. We have set it out in years (how many years until the refinance/redraw is required):

Time (Years) 1 2 3 4 5 6
Cost ($) 1,500 1,500 1,500 1,500 1,500 1,500
Loan Balance ($) 500,000 500,000 500,000 500,000 500,000 500,000
Cost 0.30% 0.15% 0.10% 0.08% 0.06% 0.05%

We can then apply this across a range of values – with years along the top and the amount borrowed along the side.

1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 YEAR 6 YEAR
$125,000 1.20% 0.60% 0.40% 0.30% 0.24% 0.20%
$250,000 0.60% 0.30% 0.20% 0.15% 0.12% 0.10%
$375,000 0.40% 0.20% 0.13% 0.10% 0.08% 0.07%
$500,000 0.30% 0.15% 0.10% 0.08% 0.06% 0.05%
$625,000 0.24% 0.12% 0.08% 0.06% 0.05% 0.04%
$750,000 0.20% 0.10% 0.07% 0.05% 0.04% 0.03%
$875,000 0.17% 0.09% 0.06% 0.04% 0.03% 0.03%
$1.0m 0.15% 0.08% 0.05% 0.04% 0.03% 0.03%
$1.125 0.13% 0.07% 0.04% 0.03% 0.03% 0.02%
$1.25m 0.12% 0.06% 0.04% 0.03% 0.02% 0.02%

I will revisit the results after Approach 2. Any borrower should take this approach as a maximum they should be willing to forgo for Approach 2: having flexibility costs money and this table shows you how much it should cost. It costs $1,500 to refinance and if the loan balance is higher or you plan to redraw very infrequently, simply wait until you need to redraw and pay the $1,500 – certainly if you save money elsewhere.

Keep Savings Separate, Pay the Taxes

Here, we assume you have savings as a percentage of the total loan balance, ranging from 1 to 20% and that borrowers will redraw every 2 years.

% of mortgage held as cash 1% 2% 4% 5% 10% 20%
Cash Balance ($) 5,000 10,000 20,000 25,000 50,000 100,000
Mortgage Rate 4.00% 4.00% 4.00% 4.00% 4.00% 4.00%
Savings Rate 2.50% 2.50% 2.50% 2.50% 2.50% 2.50%
Mortgage Cost ($) 200 400 800 1,000 2,000 4,000
Interest Earned ($) 125.00 250.00 500.00 625.00 1,250.00 2,500.00
Tax 30% 30% 30% 30% 30% 30%
After Tax Earnings 87.5 175 350 437.5 875 1750
Net Cost 113 225 450 563 1,125 2,250
Years 2 2 2 2 2 2
Total ($) 225 450 900 1,125 2,250 4,500
Cost per annum 0.05% 0.09% 0.18% 0.23% 0.45% 0.90%

These tables present a lot of data but it can be simplified into 3 sections:

If you have a very low savings balance (1-2%), using the offset has less value as you are not saving much money. We assume this is at best 0.1% per annum benefit in having an offset.

If you have reasonable savings, which comes to about 5% of your outstanding mortgage, the potential cost of this approach is 0.18% to 0.23% per annum (18bps to 23bps). From this point onwards, the decision is then a matter if the redraw will be made in Year 1 versus later. If you expect to redraw within a year, Approach 2 (savings & tax), otherwise Approach 1 (redraw/refinance). This caps the cost at about 0.15% (from Approach 1) as the 1-Year cost for Keep Savings in this second bracket is 0.1% and the maximum cost for Approach 1 is 0.15% if over 2 years (less if longer).

Generally, if one has a very large savings balance (10-20%) then there is limited point in borrowing. You are essentially giving the bank money by receiving 2.5% and paying 4%. Here, the best approach will be to use the redraw strategy (Approach 1) as the total cost is $1,500 and we expect the cost to be around 15bps as a maximum and reduce if you infrequently need access to the savings.

Drawing Conclusions

Offsets do add value to a borrower in that the tax benefit of reducing a liability is better than receiving interest and that interest us a lower rate than you pay.

By combining our assessment of Salary and Savings Impact, the offset puts a borrower in approximately 0.2% per annum better off: a borrower should be willing to pay up to this for the product.

There are several caveats around this:

If the savings balance is very low, the impact is reduced to about 10bps.

If the savings balance is proportionally higher, the borrower needs to consider what they are going to do with their savings: keeping large savings in cash deposits is not an optimal choice. If these savings are put into equities and earn 7% per annum, then the value of an offset account is reduced but the borrower is taking on a different financial risk that we cannot easily compare.

If you are a conservative borrower who doesn’t plan to redraw, the offset benefit may reduce to less than 10bps.

If you have other types of debt, you are better paying them off than reducing a mortgage, which typically has the lowest interest rate.

You may get access to free redraws in some home loans. Then benefit of an offset versus these is then reduced to 0.03%- 0.05% as we can use Approach 1 without facing the $1,500 cost.

Applying to a Family

Consider a family with household income of $150,000, 35% tax rate, $625,000 mortgage, $35,000 of savings and refinance frequency of 3-years.

An offset will save them:

Salary Impact: $2,264 or 0.05%

Savings Impact: Approach 1 is 0.08% (note: Approach 2 is 0.40%)

Total Impact is 0.13%, so they should only choose an Offset if the interest rate is less than 0.13% higher than a non-offset account.

What are banks charging?

The cost of an offset account ranges from 10bps to 40bps, so you need to consider if it is worthwhile versus going for the more simplified product. If a bank is charging more than 0.15% it is likely to be a financially negative decision to choose an Offset account (banks are known to gauge customers) as the bank is charging more than the likely benefit. We think most banks are charging 0.2% to 0.25% extra for offsets, so see them as being a pointless exercise unless combined with a split loan (we’ll save this for a separate blog).

Like many things, the borrowers view on how often they need to draw money is key and if the standard non-offset product allows the occasional redraw, this will help answer the question.

It may also be worth picking other loan products with no offset feature at all if they offer features that outweigh the offset’s value. The easiest example is a fixed rate product: if you think interest rates will increase, then a fixed offers potential value as those interest rates won’t go up during the fixed period.

Huffle’s FlexiFix home loan product goes beyond this. We offer the certainty of payments and the flexibility to pay off and refinance without any break costs. We believe this has substantially more value to a borrower than an offset account.

 

 

 

 

 

 

 

 

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