Interest rates are continually trending upwards in Australia and mortgage holders are feeling the pinch. What’s worse, rising costs of living and tighter lending criteria can see you trapped with your existing lender and unable to refinance to reduce your mortgage repayments.
So how do you avoid this so called, ‘mortgage prison‘?
In this article, we dissect the phenomenon of mortgage prison and provide you with some useful tips on how to avoid getting trapped in a mortgage prison.
This article is for informational purposes only. You should talk to a trusted financial advisor to determine what is right for you and your specific financial situation.
What is Mortgage Prison?
We’re talking about being ‘locked in’ to your current lender and a likely high variable interest rate.
Mortgage holders find themselves here when they are unable to refinance due to not meeting serviceability requirements.
The Australian Prudential Regulation Authority requires banks to conduct a ‘stress test’ by adding a 3 point buffer to the current market rate when assessing new borrowers loan capacity.
While these buffers are important for the stability of the banking system, it essentially means that many seasoned borrowers are being told that they can’t afford a cheaper home loan.
Conflicting, to say the least.
Lenders assess borrowers income and expenses to ensure they can afford higher repayments in the event that rates continue to rise. When this assessment determines that a borrower does not qualify for a better deal, they enter into “mortgage prison”. Borrowers therefore become locked into their lender and unable to refinance and reduce monthly repayments.
Why Has This Become A Common Talking Point in 2023?
National Australia Bank reports that 1 in 5 of its home loan customers are mortgage prisoners, and 2 in 5 of those who borrowed between 2019 and 2022 when interest rates were at their lowest [1].
The Reserve Bank has imposed consecutive interest rate hikes which has the average home mortgage owner with less income for discretionary spending.
As people have less money to spend, property prices fall, which throws out the loan-to-value ratio of your typical home loan. So we’re seeing lenders less inclined to allow mortgage holders to refinance due to deeming them as ‘high risk’.
There is pressure to reduce that aforementioned 3 point buffer in order to provoke competition between lenders and help homeowners to escape mortgage prison.
The sooner you get out, the more money you’re likely to save.
Different Types of Mortgage Prison
There are many different types of mortgage prison and reasons why you could find yourself trapped in there, such as:
Property Value Decreased
Property prices are at the mercy of an ever-changing market. If your property value has decreased since your purchase, your loan-to-value ratio will increase. Depending on your loan amount, this could land you in mortgage prison, as most lenders will not approve a loan-to-value ratio above 80% without having to pay Lender Mortgage Insurance.
LVR is calculated by dividing the loan amount by the value of the property and multiplying this by 100 to get the percentage. For example, say you have $400,000 outstanding on your mortgage and your property is valued at $500,000: 400000/500000 x 100 = 80%.
Loan Serviceability Standards
When you apply to refinance, new lender’s serviceability requirements are used to determine whether or not you are capable of repaying your loan. The strict lending criteria make it especially difficult for those with debt or poor credit history.
The bank will assess the application based on their current advertised rate plus around 3% – the home loan buffer.
So, if the current mortgage rate is 6.70%, you need to prove you can service a loan of 9.70%.
If you can’t, you may enter mortgage prison.
Lower Borrowing Power
Higher interest rates and economic conditions, such as the rising cost of living, reduces your borrowing capacity. You may not be able to borrow the required amount to service your existing mortgage.
Decreasing your debt-to-income ratio is likely the best way to increase your borrowing power and avoid falling into mortgage prison.
Credit Score Issues
Your credit rating is provided by a 3rd party and can guide your lender’s calculation on the risk of your loan application based on credit history, employment, stability, income and security.
Tougher lending criteria have made it more difficult for those with blemishes on their record to borrow or refinance.
If a lender assesses your application as risky, you may become a mortgage prisoner.
Age
Some lenders are hesitant to refinance mortgages for borrowers who are over 50 years old; this is often due to higher risks in the ability to make home loan repayments as the expected retirement age draws nearer.
Fixed Rate Interest Expiring
As fixed rate interest terms expire, your interest rate will increase to the variable rate which is likely to be significantly higher. Lenders will use the stress test to assess whether or not you can afford the increase and possible future interest rate hikes.
Your lender may determine that you can’t afford the higher repayments and your loan-to-value ratio is too low to refinance, meaning you are now a mortgage prisoner.
How To Avoid Mortgage Prison
Without a viable exit strategy mortgage holders could see themselves paying tens of thousands extra in interest over a few years.
Here are our tips to bypass or escape mortgage prison:
- Shop Around:
As your fixed term draws to an end, organise meetings with your bank and financial advisor, or utilise comparison sites to start seeing what you options are. Finding the right partner for your next mortgage will be key to avoiding mortgage prison as they help you negotiate the right loan term for you.
- Improve Your Credit Score:
Avoid making excessive credit enquiries, as this can send a red flag to lenders that you are not in the best financial situation. Pay your bills on time and go through your records to correct any errors.
Consistent employment and income will positively impact your credit score. Try and remain in your place of employment as your fixed term comes to an end.
- Decrease Debt:
Consolidate all of your high interest debt obligations into one loan which is likely to have a comparatively lower rate. You could consider merging credit card or other debt and personal loans into your home loan.
Paying down your debt and lowering your credit card limits may also make you a more attractive borrower in lenders eyes.
- Consider Refinancing:
Mortgage owners with steady repayment histories and consistent incomes are likely to have more negotiating power despite the possibility of further interest rate rises. Talk to a knowledgeable broker to discuss the potential advantages of refinancing with a new lender.
Can Refinancing Help You Avoid Mortgage Prison?
Major and minor lenders have reduced their buffer from 3 points to 2 points or lower to attract:
1. New loans of those entering the property market
2. Those wishing to consolidate their debt, and
3. Those needing to refinance their home loans to reduce mortgage repayments.
To stay competitive, other mortgage lenders may consider reducing their buffer in the near future.
Refinancing can be a useful method to avoid potential pitfalls of being locked into one lender.
Refinancing can allow you to extend your loan term, meaning more interest paid over the life of your loan but reduced monthly repayments, easing financial stress.
If your property has accumulated sufficient equity you may be able to tap into that equity through a cash out refinance. This lump sum could be used to pay down high interest debt or make valuable home improvements which positively impact your financial situation. Speak with an experienced loan specialist before considering this path, as home equity loans require you to use your home as collateral.
At the very least, refinancing allows you to modify your loan terms, potentially switching from a fluctuating variable rate to a steady fixed interest rate, providing you with a term of predictability for the future.
Refinancing can be an escape route but is certainly not a one-size-fits-all approach. You must factor in closing costs and fees and weigh these up against potential benefits. You should speak to a financial advisor to determine if refinancing is right for you and your current financial situation and goals.
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Summary
Mortgage prison is a restrictive and financially detrimental place that you do not want to be in.
Taking steps to avoid it is not only wise but necessary to stay afloat in a volatile market. Don’t become of the 1 in 5 mortgage owners locked into high interest rates; work at improving your credit score, decrease your debt and compare the market.
Some banks and lenders are reducing serviceability buffers, making it easier for borrowers to refinance evoking a competitive response from new lenders and assisting the release of mortgage prisoners.
Don’t wait to be in mortgage prison to find an escape route: be proactive about your home loan and chat to an experienced mortgage broker early.
Disclaimer: This article is not intended as legal, financial or investment advice and should not be construed or relied on as such. Before making any commitment of a legal or financial nature you should seek advice from a qualified and registered Australian legal practitioner or financial or investment advisor.
References
[1] Financial Review, 2023. More Lenders Offer Escape Route From ‘Mortgage Prison’. afr.com/wealth/personal-finance/more-lenders-offer-escape-route-from-mortgage-prison-20230524-p5daxe
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