Loan interest

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

Home loan interest rates are likely to continue to favor homeowner borrowers over property investors under finalized changes to bank capital rules.

Banking regulator APRA released its new bank capital framework late Monday afternoon, which it described as “more risk-sensitive”.

As a result, the currently higher interest rates faced by real estate investors, borrowers with small deposits or equity, and those on interest-only loans are likely to persist or even increase.

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

While the size of a loan relative to the bank’s valuation of the property (loan-to-valuation ratio, or LVR) was previously the primary measure of risk considered by the regulator, APRA will now also make the distinction between loans to homeowners and investors, thus in the form of principal and interest versus interest-only loans, the latter being in both cases considered riskier.

In the context of capital requirements, riskier loans resulting in higher capital requirements will mean 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 need to hold to absorb losses from bad debts, especially in times of financial or economic stress.

It’s relatively expensive because the banks have to provide a sufficient return to the investors (shareholders and bondholders) who put their money on the line in the event of sourness.

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 the bank will charge.

APRA changes the dial slightly by altering the “risk weighting” it applies to different forms of lending.

Risk weighting is essentially an estimate of how risky a loan is and therefore its importance in the “risk-weighted assets” against which banks must hold capital.

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

So, for example, if a bank were required to hold 10% equity, it would need to hold $100,000 of equity against a $1 million loan with 100% risk weighting, but only $40,000 against a loan of the same size with a risk weight of 40 percent.

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

Thus, a bank would need to hold twice as much capital against the 80-90% LVR loan than against the less than 50% loan.

The risk of a mortgage increases when the size of the loan is larger relative to the valuation of the property.(Provided: APRA)

As you can see from the graph, for a given LVR, investor loans and longer-term interest-only loans will have a higher risk weighting than owner-occupied principal and interest mortgages.

Therefore, they are likely to continue to have higher interest rates. The advantage may go to homeowners with large deposits or a lot of equity in their home, who will likely continue to see 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

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

However, the regulator has indicated that this is due to lower risk weightings for commercial real estate and corporate lending, 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,” notes a briefing paper released by the regulator.

About two-thirds of Australian banks' assets are residential mortgages, about three times as many as in the UK and double in the US.
About two-thirds of Australian banks’ assets are residential mortgages, about three times as many as in the UK and double in the US.(Provided: APRA)

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

APRA also noted that risk weights for small and medium enterprises will be lowered for banks using its standardized 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 lending, with property development being by far the riskiest.(Provided: APRA)

APRA Chairman Wayne Byres said an unquestionably 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.

“While the Australian banking sector is already highly capitalized by international standards, the new capital framework will help ensure it remains that way.”