Serviceability vs Affordability

Lots of questions coming in about what the banks are doing, where rates are headed and how much I can borrow.  Andrew Mirams from Intuitive Finance looks at the difference between serviceability and affordability.
Kevin:  One word comes up time and time again when we’re talking about property, and that is about affordability. There’s another word, too, that you need to be concerned about, and that’s serviceability. What’s the difference, and how do you apply them to your own individual situation? I’m going to ask that question of Andrew Mirams from Intuitive Finance.
Hello again, Andrew, and thanks for your time.
Andrew:  Hi, Kevin. How’s things?
Kevin:  Good, mate. Run me through the differences between affordability and serviceability.
Andrew:  That’s a great question, Kevin, and at the moment with APRA and our regulators looking over the lenders’ shoulders and just making sure that they have some strong prudent lending standards, the differential is really widening.
If we talk about affordability, that’s what you’re literally paying out in terms of what rate you’re paying and your interest-only payments or principal and interest payments, and this is where the differential is starting to widen. With rates at all-time lows, to hold money it’s arguably never been cheaper than what it is today, whether that’s a home loan or an investment property, etc., so with really low rates, that’s your affordability question.
Also, if they’re interest-only versus principal and interest – there needs to be some analysis around that – then obviously your affordability is really low because you’re getting a rent coming in and it’s not uncommon for that rent to meet the best part, or if not, if it’s positively geared, meeting all your interest repayments.
On the other side, you have serviceability, and this is where, of recent times, the regulators have been doing a lot of work around. What they’re doing is lenders are basically being asked to service, and even with the recent rate decrease, lenders haven’t adjusted their serviceability rate. So they’re still servicing debts at 7.5% to 8%, around that sort of figure, and if you have an interest-only loan of, say, a five-year term in there, you’re actually servicing it over only the remaining term, being the 25 years. So you have the double whammy of a shorter term with a higher interest rate that you actually have to meet your serviceability.
This is where clients and a lot of people aren’t quite understanding the difference between what it’s actually costing them – which is very, very low – versus now what the regulators are saying: “No, if clients can’t meet those standards, you’re not to lend any more money to them.”
Kevin:  That buffer is increasing, I take it, between affordability and serviceability.
Andrew:  Absolutely.
Kevin:  That’s largely driven by the banks trying to be conservative, I guess. Is that right?
Andrew:  Well, it’s not really the banks. The banks make money by lending money, Kevin, so that’s not lender driven; this has very much been the regulators. In the middle of 2015, they came out and said, “Right, all the lenders, you’re either going to have to put up and raise more capital, or you’re going to have to start to change your standards.”
They were worried about some of the lending standards that they didn’t believe were that prudent, and I agree with a lot of the measures. Really high LVRs, 97% LVRs, to people investing in investment probably just because the market’s going, I think, wasn’t prudent. There were some things around the serviceability measures that I don’t think were prudent.
I do think they might have over-extended a little bit of recent times because rates being so low, so if you think about all the banks servicing at 7.5% to 8% as a ballpark, but that’s about where it is, I don’t think any time soon we’re going to be having rates back up there, but that’s what lenders are now being asked to do it at by the regulators. And if they don’t tack on then the regulators are just going to say, “Right, you can just put more capital aside,” and that’s a greater cost to a bank or a lending institution than actually making a few tweaks to their servicing calculator.
Kevin:  That figure you mentioned, 7.5% to 8%, that’s the figure that the bank calculates whether or not you can actually service the loan. Is that right? They say, “If the interest rate were at 7.5% or 8%, could this person pay it back?” Is that what you’re saying?
Andrew:  Yes, correct. Absolutely. You’re probably looking at most people at the moment with rates at around the low fours, 4% to 4.5%, so you’re actually putting a 3% differential. Now, that’s been around for a long time. It was normally about 2% or so, but as rates have been coming down, the banks have just held it at that rate, so as that gap widens, so just think about that’s a 3% differential on 4.5%, it’s 66% loading, that’s pretty significant when you have all-time lows.
That’s what the regulators have concern over, that with really low interest rates, people are going to get themselves in too much debt and that’s going to create a market that if and when rates do increase down the track, there might be [4:57 inaudible] and people who are in a position that they just can’t service their loans.
Kevin:  Are you seeing a lot of mortgage stress at present?
Andrew:  No, I’m not. I guess there are certain markets where that is the case. I’m fortunate with our investor clients that I think we set them up with big buffers so that they have the equity and the capacity to be able to manage their loan, but at the same time, rates are at all-time lows, so if there is some mortgage stress out there then those clients probably shouldn’t have been lent to in the first place. And that, again, is what the regulators are trying to avoid.
Kevin:  Do you work on the same kinds of buffers that the banks work on? In other words, are you still calculating at 7.5% or 8%, or are you even higher?
Andrew:  No, we’re bound to use those sort of figures. I work on a buffer as well as an equity buffer, so the clients have either cash or equity aside so that if and when… See, when you’re buying a property or an investment property, it’s about buying time; it’s not actually about buying the property.
What the rates are today, you know if you’re taking a loan over 30 years, things are going to go up and down, so it’s about having the time on your side so that if there are any short-term blips in the road where someone might lose their job and in between getting a new job, you need to have some equity there to make sure you can make your commitments while that’s happening. Hopefully, there’s enough buffer there that’ll allow people to get back on their feet.
In terms of servicing rates, yes, we’re bound by those rates as well by the lenders. That’s just the playground that we’re all playing on at the moment.
Kevin:  Yes, well said. Andrew Mirams there from Intuitive Finance, and an interesting look behind the scenes at how you are assessed if you’re going to go for a loan.
Andrew, thanks for your time.
Andrew:  My pleasure, Kevin. Thank you.

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