The Australian Prudential Regulation Authority (APRA) has updated its Prudential Practice Guide APG 223 Residential mortgage lending on sound risk management practices for residential mortgage lending. The Guide sets out APRA’s views on credit assessment for housing loans.
In its letter to ADI’s APRA made a number of observations:
A loan should not automatically be considered prudent merely by having a positive net income surplus. An ADI should satisfy itself that it is applying sufficient buffers to achieve prudent serviceability outcomes.
APRA expects that ADI serviceability policies should incorporate an interest rate buffer of at least two percentage points. A prudent ADI would use a buffer comfortably above this level.
Assessment and verification of income, living expenses and other debt commitments
When assessing a borrower’s income, APRA’s view is that a prudent ADI would discount or disregard temporarily high or uncertain income. Similarly, it would apply appropriate adjustments when assessing seasonal or variable income sources.
For example, significant discounts are generally applied to reported bonuses, overtime, rental income on investment properties, other types of investment income and variable commissions; in some cases, they may be applied to child support or other social security payments, pensions and superannuation income. Prudent practice is to apply discounts of at least 20 per cent on most types of non-salary income; in some cases, a higher discount would be appropriate. In some circumstances, an ADI may choose to use the lowest documented value of such income over the last several years, or apply a 20 per cent discount to the average amount received over a similar period.
APRA notes that in recent years a number of ADIs have made considerable efforts to reduce the ability for serviceability assessment parameters, such as haircuts, to be manually adjusted or overwritten.
Verification of non-salary income
APRA believes that two years as a reasonably prudent timeframe for assessing non-salary income may be adequate in some circumstances, but that ADIs should use appropriate judgement as to whether a longer period should be used.
APRA accepts that there are different methodologies to account for investment property costs. It confirmed the primary purpose of applying haircuts to expected rental income is to account for instability in that income due, for example, to the risk of non-occupancy. However, as rental income is typically less stable than expenses relating to investment properties, a prudent ADI would apply the haircut to gross rental income rather than net rental income.
In the case of investment property, common industry practice is to include expected rent on a residential property as part of a borrower’s income when making a loan origination decision. However, it would be prudent to make allowances to reflect periods of non-occupancy. ADIs would normally place less reliance on third-party estimates of future rental income than on actual rental receipts from a property.
In APRA’s view, prudent serviceability policies incorporate a minimum haircut of 20 per cent on expected rental income, with larger haircuts appropriate for properties where there is a higher risk of non-occupancy. A prudent ADI would also account for a borrower’s investment property-related fees and expenses (e.g. strata requirements), for example, by including property expenses in estimates of living expenses or by deducting property expenses from expected net rental income. Good practice would be for an ADI to place no reliance on a borrower’s potential ability to access future tax benefits from operating a rental property at a loss. Where an ADI chooses to include such a tax benefit, it would be prudent to assess it at the current interest rate rather than one with a buffer applied.
APRA’s view is that that the Household Expenditure Measure (HEM) or Henderson Poverty Index (HPI) should be scaled to a borrower’s income. APRA is not convinced that it is appropriate to use a borrower’s geographic location to determine an appropriate margin above the relevant living expense index Until recently very few ADIs employed any margin above living expense indices, instead applying a flat baseline HPI or HEM assumption to all assessments.
APRA is of the view that a prudent ADI would always use the most up-to-date indices.
APRA also expects ADIs to use a suitably prudent period for assessing the repayment of credit card or other revolving personal debt when calculating a borrower’s expenses. For example, an ADI may assess a borrower’s repayment obligation for credit card or other revolving personal debt using a rate of three per cent per month on the total committed limit for such facilities.
Updating the serviceability assessment
APRA expects an ADI to undertake a new serviceability assessment whenever there are material changes to the current or originally approved loan conditions. Such changes would include a change of repayment basis from principal and interest to interest-only, or the extension of an existing interest-only period. A change from a fixed-rate basis to a floating-rate basis (or vice versa), or an extension in the tenor of the loan are other examples of material changes.
A new serviceability assessment would be appropriate for any change that increases the total repayments over the life of the loan, even when immediate periodic repayments are lower than under the previous loan conditions.