Home loan interest rates will continue to favor homeowners over investors under new APRA rules

Mortgage interest rates are likely to continue to favor homeowner borrowers over real estate investors under the finalized changes to bank capital rules.

The banking regulator APRA published at the end of the afternoon its new bank capital framework, which it described as “more sensitive to risk”.

As a result, the currently higher interest rates facing real estate investors, borrowers with small deposits or little equity, and those receiving interest-only loans are expected to stay or even increase.

However, given that a very similar project was reported a year ago, it is understood that APRA does not expect big changes in market prices for mortgages and other loans as a result of the final changes.

While the amount of a loan versus the bank’s valuation of the property (loan-to-appraisal ratio, or LVR) was previously the primary risk measure considered by the regulator, APRA will now also differentiate between loans to individuals. owner-occupiers and investors, thus in the form of principal and interest compared to interest-only loans, the latter being in both cases considered to be more risky.

In the context of capital requirements, riskier loans resulting in higher capital requirements will result in higher costs for the bank and, therefore, for the borrower.

How do capital requirements work?

Here’s how it will work, in very simplified terms.

Capital is the buffer that banks must hold to absorb losses from bad debts, especially in times of financial or economic crisis.

It is relatively expensive, because the banks have to offer a sufficient return to the investors (holders of stocks and bonds) who put their money on the line in the event of a crisis.

For this reason, the level of capital required for a particular type of loan is an important determinant of its cost, or the interest rate that the bank will charge.

APRA shifts the dial slightly by changing the “risk weight” it applies to different forms of lending.

Risk weighting is essentially an estimate of how risky a loan is and therefore how much it should count in the “risk-weighted assets” against which banks are required to hold capital.

If a loan has a 100 percent risk weight, its entire value is considered at risk. If it has a 40 percent risk weight, the bank need only hold capital against that risky party.

So, for example, if a bank were required to hold 10% equity, it would have to hold $ 100,000 of equity against a million dollar loan with a 100% risk weight, but only $ 40,000 against a. same size loan with a 40 percent risk weighting.

To give a simple example of APRA’s new policy, as part of its “standardized” model (used by small and medium-sized banks), the risk weighting on an owner-occupant home loan is less than half the value of the good is 20%. percent, but that’s double (40 percent) for mortgages with a loan-to-value ratio (LVR) between 80 and 90 percent.

Thus, a bank should hold twice as much capital against the LVR loan at 80-90 percent as against the one below 50 percent.

The risk of a mortgage increases when the <a class=loan amount is larger compared to the valuation of the property.” class=”_1sqAO WIJbJ” data-component=”Image” data-nojs=”true” data-src=”https://live-production.wcms.abc-cdn.net.au/86f7f3066251dc67f4b7def21f150886?src” data-sizes=”100vw”/>
The risk of a mortgage increases when the loan amount is larger compared to the valuation of the property.(Provided: APRA)

As you can see from the graph, for a given LVR, investor loans and long-term interest-only loans will have a higher risk weight than homeowner principal and interest-only mortgages.

Therefore, they are likely to continue to have higher interest rates. The benefit may go to homeowners with large deposits or high equity in their home, who will likely continue to benefit from relatively cheaper mortgages.

Although the standardized risk weights do not apply to large banks and certain other large institutions that use internal risk models approved by APRA, the same principles will apply.

Business loans could become cheaper than mortgages

APRA figures show that large banks, on average, are likely to see a slight reduction in their risk-weighted assets under the new rules, which may mean they may reduce their capital slightly. they hold.

However, the regulator said this is due to lower risk weights for commercial real estate and corporate loans, while mortgages will see a slight increase in overall capital requirements.

“One of the objectives of the new framework has been to strengthen the amount of capital held by banks for residential mortgages, given the industry’s concentration in this asset class,” noted a document from information published by the regulator.

About two-thirds of Australia's bank assets are residential mortgages, about three times more than in the UK and double the US.
About two-thirds of Australia’s bank assets are residential mortgages, about three times more than in the UK and double the US.(Provided: APRA)

“Under the new framework, APRA increased capital for residential mortgages relative to other asset classes, and better distinguished between higher and lower risk loans.”

APRA also noted that the risk weights for small and medium enterprises will be lowered for banks using its standard approach, potentially facilitating slightly cheaper lending to this sector.

APRA chart showing the average risk weights of various types of loans.
Residential property is still considered by far the safest form of credit, with real estate development by far the riskiest.(Provided: APRA)

APRA President Wayne Byres has said that an unmistakably strong banking sector is essential to the stability of the financial system.

“Capital is the cornerstone of the security and stability of the banking system,” he said.

“Although Australia’s banking sector is already heavily capitalized by international standards, the new capital framework will help ensure it remains so.”

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