How can you avoid becoming trapped in a mortgage prison?

At a time when interest rates, inflation and cost of living pressures continue to hamper consumer confidence, Aussie households are looking to rein-in spending by any means necessary. 

For those with budgets bursting at the seams, refinancing remains top priority with ABS lending data to December revealing record highs continue to be recorded in the value of owner occupier refinances. 

This coincides with the $268 billion worth of record-low fixed-rate home loans from the major banks set to expire in 2023, forcing many Aussie households to assess finances in bracing for a significant uplift in interest rate repayments. 

What is a mortgage prison?

Many Aussie households are bracing for what is to come by navigating the home loan market, but may be faced with the prospect of becoming trapped in a mortgage prison.

A mortgage prison is the catch-22 scenario where homeowners are stuck paying an uncompetitive rate, unable to refinance to a cheaper home loan due to a combination of:

• Increased HEM calculation based on higher living costs
• Increased interest rates, serviceability buffer, ruling you out as a prospective borrower
• Interest rate rises and cost of living affecting borrowing power
• And/or a lower home valuation from the new prospective lender, which also eats into equity

CommBank financial results for July to December 2022 released Wednesday show the average single owner occupier mortgage applicant has seen their borrowing power reduced by some 40 percentage points from the peak in late 2020/early 2021.

More than one-in-10 homeowners are borrowing at capacity, a 1.8 percentage point increase from the six months prior.

Two Red Shoes Mortgage Broker Brett Sutton has outlined a number of tips for Aussie households to both insulate against the risk of a mortgage prison and escape a mortgage prison without the risk of potential foreclosure.  

1. Manage debt-to-income ratios

When looking to refinance, Mr Sutton notes it is important to be mindful of how additional consumer debt such as car loans, credit cards, store cards and even loans for investment properties can impact your borrowing capacity.

“Many major lenders have a debt-to-income ratio policy of six-times the annual income of applicants,” he said. 

“Rarely is the owner-occupied loan the problem. More often it's the subsequent debts and loans that a mortgagor has taken out after getting their home loan that’s causing the issue.

“Mortgage holders should consider closing or reducing their unused credit cards, timing the payout of car loans with the expiration of the fixed-rate loan roll off, and temporarily halting investment spending to reduce their risk.”

In this rising interest rate environment, many lenders have reduced their lending for debt-to-income ratios above six-times, and won't lend above seven-times.

2. Refinance early to get ahead of the game

Mr Sutton details as part of responsible lending policy banks stress test the loan at a rate of 3% above the interest rate offered.

“An example of this is when rates were lower you would have applied for a 2.00% p.a. mortgage with a buffer of 3% which equals a total of 5%. Now rates are 5.00% p.a., you may no longer qualify with the standard assessed buffer of 3%,” Mr Sutton said. 

“To avoid this scenario, it’s best to refinance sooner rather than later. Those concerned about an upward trend in interest rates should do what they can to maximise income prior to applying by taking additional hours at work or waiting until after the pending pay increase to apply.” 

To put the number of Aussies seeking out cheaper home loan rates into perspective, PEXA Insights data revealed Australians refinanced at record levels in 2022 with more than 378,000 refinances recorded in New South Wales, Victoria, Queensland and Western Australia, up 11.4% on the prior record year. 

This trend is expected to continue throughout 2023 spurred on by fixed interest rate expiry and banks offering enticing cashback offers and deals to entice mortgagees to switch. 

See more: Home loan deals and offers February 2023

3. Navigate changes to banks’ living expense calculations

Mr Sutton says due to increased cost-of-living expenses caused by inflation, banks have increased the number they use to calculate living expenses. 

“Prior to applying for refinancing, mortgage holders should consider reducing discretionary spending for 3-6 months,” Mr Sutton said. 

“Applicants should also inform their bank or broker of any items that might mitigate their living expenses such as having the private use of a company vehicle.”

4. Pay attention to banks’ age policy

Mr Sutton says it’s important to pay attention to age policies applied by banks and lenders, given each lender has a different policy in regards to expected retirement age. 

“This is particularly critical for those in owner-occupied situations where the loan term will exceed the bank’s deemed retirement age,” Mr Sutton said.  

“Mortgage holders should keep this in mind as they plan for the future. Having a viable exit strategy such as downsizing can assist with managing potential pitfalls.”

Many banks require an exit strategy when either borrowing for a home if you're over 50, or if your loan term will persist into retirement, and thus a loss of regular income.

Borrowers' exit strategies can include paying for a home loan with their super balance, or other investments and passive income.

5. Keep an eye on loan-to-value ratios

As property values across the country plummet into negative growth, Mr Sutton says those who purchased recently at a loan-to-value ratio (LVR) of 95% will be in a position of negative equity and unable to refinance if the property market retracts 10%, as many economists forecast.

Some markets are already recording losses above the 10% watermark.

This is further echoed by PEXA Chief Economist Julie Toth noting recent mortgagees tend to have larger mortgages and higher mortgage costs relative to their incomes, compared to home-owners with older loans. 

“With property prices receding from their recent record peaks in many suburbs, increasing numbers of mortgagees will face higher mortgage-to-valuation ratios on their home,” Ms Toth said. 

“This change in valuation ratios will materially affect the way in which affected mortgage-holders respond to rising rates, via mortgage refinancing or property resale. At its worst, this situation can push mortgage-holders into reluctant sales, negative equity, so-called ‘mortgage prison’, and/or financial stress."

Having a budget and sticking to it, cutting back on spending, reducing debts, avoiding payday loans and increasing income are just some methods to potentially increase your home loan serviceability.

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