APRA’s article “Loan serviceability standards in housing lending” (in Insight Issue Two 2013) identifies areas in housing loan approval standards where improvements are needed. Some of these reflect the National Credit Act responsible lending requirements.

The article summarises a review of ADIs that focussed on the income tests that ADIs use to assess whether borrowers can afford the interest and principal repayments on their loans. A total of 27 ADIs participated in the review, including major banks, regional banks, credit unions and building societies. Together, these ADIs represented around 97 per cent of total ADI housing loans as at March 2013.

According to APRA:

A strong focus on debt serviceability is critical in a low interest rate environment. In particular, low interest rates can mask debt serviceability assessments, creating opportunities for borrowers to increase their leverage. The resulting growth in demand for housing loans can also put pressure on housing lending standards as ADIs compete to maintain or increase their market share. ADIs need to carefully monitor the debt servicing capacity of their borrowers over the duration of housing loans, not just at origination, to ensure that borrowers are able to manage the transition to higher interest rates, when that inevitably occurs.

APRA identified the following as forming a prudent approach to debt serviceability:

• Clearly documented policies and procedures for evaluating loan serviceability, subject to effective governance arrangements and board oversight.
• A set of consistent serviceability criteria across all of an ADI’s mortgage products.
• Application of an interest rate buffer to stress new and existing loan commitments, which is regularly reviewed in relation to the interest rate cycle and key economic indicators.
• Inclusion of an interest rate floor in serviceability assessments, based on the average mortgage interest rate over an appropriately long time period, being at least one cycle in interest rates.
• Use of a borrower’s declared living expenses as a more representative measure of their actual living expenses than the Household Expenditure Measure (HEM) or the Henderson Poverty Index (HPI) indices.
• Where the HEM or HPI indices are used, the addition of a margin to the relevant index linked to a borrower’s income, and regular updating of these indices.
• Formal procedures to verify a potential borrower’s existing debt commitments and to identify possible undeclared debt commitments.
• A framework that clearly defines overrides/exceptions and includes the documentary requirements for override/exception decisions and how overrides/exceptions are to be identified, reported and monitored.
• Regular override/exception reporting to the appropriate level of management and to the board.

APRA identified hindsight reviews (or independent reviews of compliance with serviceability policy) of housing loan portfolios as good practice

The review also identified that, in a minority of ADIs, the mortgage documentation supporting the serviceability assessment was incomplete and that there were inaccuracies in the income verification process.

APRA’s detailed comments included:

Serviceability models

ADIs use three kinds of serviceability models to assess a borrower’s ability to repay a mortgage: the net income surplus (NIS) model4, the debt servicing ratio (DSR), or a combination of both.

The majority of ADIs surveyed used the NIS model. In some cases, ADIs only require that the net income surplus be positive for a mortgage application to be automatically approved. Conceptually, this would mean that a trivial change in a borrower’s circumstances could adversely affect their capacity to service the loan. It is important for ADIs to ensure that borrowers approved at the limits of NIS or DSR models can continue to service their loans in the face of even modest adverse changes in circumstances. Hence, APRA expects these models to contain appropriate interest rate buffers and/or margins on living expenses when used to make serviceability assessments.

Living expenses

Understanding a borrower’s living expenses is crucial as these are key cash outflows that influence the outcome of the serviceability assessment. All ADIs surveyed used either the Household Expenditure Measure (HEM) or the Henderson Poverty Index (HPI) in their loan calculators to estimate a borrower’s living expenses. The HEM or HPI indices are calibrated to reflect the required expenses for a basic standard of living. Their wide use reflects their simplicity in application but they do not necessarily reflect an applicant’s actual living expenses, which can be considerably higher. Sole reliance on these indices as a measure of a borrower’s living expenses is not considered prudent practice.

Recognising this, some ADIs using the HPI added a margin over the index but the manner in which the margin was applied varied. Margins were not generally linked to the borrower’s income level. Many ADIs also require borrowers to provide details of their living expenses, and use declared living expenses if they are higher than the HEM or HPI indices. However, declared living expenses were generally not validated.

APRA expects ADIs to use a borrower’s declared living expenses as a more representative measure of their actual living expenses than the HEM or HPI indices. However, if the HEM or HPI is used, APRA would highlight two areas for improvement. One is to add a margin linked to the borrower’s income to the relevant index. The other is to update the HEM or HPI used in loan calculators on a frequent basis, particularly given that updated figures for these indices are published each quarter.

Verification of income and other debt obligations

The majority of ADIs had detailed policies requiring a borrower’s employment and other income sources to be verified against third-party evidence. However, it was not common practice to extend this to the verification of a borrower’s other declared debt commitments, unless the borrower was refinancing loans. Moreover, there was no indication that ADIs had appropriate policies and procedures for ensuring that borrowers do not have undeclared debt obligations.

APRA expects ADIs to have formal procedures to verify a potential borrower’s existing debt commitments, irrespective of whether these commitments are being refinanced by the ADI, and to identify possible undeclared debt commitments.