The rising cost of living is leading Australian borrowers to look for more ways to save money. If you happen to be a part of that tribe, refinancing your mortgage to a lower rate could be one of the simplest ways to return some of your savings to your pocket.
But what if you cannot refinance to a lower rate home loan? In other words, you find yourself imprisoned by your mortgage.
What is a mortgage prison?
Mortgage prison refers to a situation where a borrower cannot refinance their home loan for some reason, such as low equity or not meeting the new serviceability criteria. Falling property prices seem to be responsible for many such cases.
Borrowers were already having a difficult time managing their repayments in the face of back-to-back interest rate hikes. Falling property prices over the last few months only made the situation worse.
Declining property values can put borrowers at risk of negative equity, trapping them in a mortgage prison.
Negative equity means that the value of a property is less than what you owe on it. If you recently purchased your house, you may find your property value has declined, and your equity in the home is less than 20%.
This could happen even if you paid a 20% deposit at the time of buying and have been making regular repayments on your home loan. If you purchased at the peak of the property prices in your area, devaluation of the property could erode your equity significantly. You are also at risk if you snapped the house at a decent rate but purchased it with a low deposit.
Another reason why you may find yourself trapped in your mortgage is the new serviceability criteria.
In 2021, The Australian Prudential Regulation Authority (APRA) made some changes to the mortgage lending standards. It asked the lenders to increase the minimum serviceability buffer for assessing home loan borrowers to at least 3%.
Serviceability refers to your ability to repay a home loan. When lenders assess your home loan application, they typically add a buffer to the advertised interest rate to check your serviceability at a higher rate. This helps them determine whether you’ll be able to afford the loan if the interest rates were to rise suddenly.
In the past, the serviceability buffer was 2.5%. So, if you qualified for your home loan in 2020 when the interest rates were low, the lender would have calculated your serviceability at a rate of 2.5% more than the advertised rate.
Let’s assume that the rate you qualified for in 2020 was 2% per annum. Fast forward to today (Dec 2022), Australia’s average home loan rate is around 4.3% per annum for new borrowers.
When you apply to a lender for refinancing, they will calculate your serviceability at a much higher rate of 7.3% per annum (assuming an interest rate of 4.3% per annum) after including the serviceability buffer. Depending on your financial situation, you may struggle to repay the loan at higher interest rates, which could prevent you from refinancing your home loan.
Bad credit can also bind you to your mortgage. Defaulting on your loan or other repayments can hurt your credit score. Lenders are typically wary of borrowers with poor credit scores and are unlikely to approve them for a refinance.
How can you avoid being a mortgage prisoner?
While it may not be possible for you to control the rising interest rates or falling property prices, there are some steps you can take now to avoid being caged by your mortgage in future.
Build equity in your home
If you bought your house with a low deposit, falling property prices could increase your loan-to-value ratio (LVR), making it difficult for you to refinance. One way you could potentially counter this problem is by paying more than your minimum repayments.
Making extra repayments towards your home loan will help you build equity faster and also save you money in interest charges. By paying more when the interest rates are still relatively low, you can also cushion yourself from the impact of rising interest rates to an extent.
Improve your serviceability
Your serviceability refers to your ability to repay a loan. Your income and expenses are both used to determine your serviceability. If you can’t increase your income, you could at least try to cut down on your expenses to improve your serviceability.
Letting go of unnecessary subscriptions, hunting for better deals on everything from your internet plan to insurance premiums, and cutting discretionary expenses could help you escape the mortgage prison.
It also helps to reduce your debts, as lenders will also check your debt-to-income ratio when approving a refinance loan.
Debt-to-income ratio signifies how much of your income goes towards servicing your various debts. Paying off any personal loans and reducing your credit card limits could help you improve your debt-to-income ratio.
Build your credit score
Lenders typically reserve their best rates for customers with high credit scores. You can improve your credit score through good financial behaviour, such as paying all your bills on time, reducing your debts, and not making multiple credit applications simultaneously. At the same time, you should also remember not to skip any of your home loan repayments to maintain your credit score.
If you’re finding it challenging to keep up with your repayment schedule, it’s advisable to contact your lender and inform them of your circumstances before you default.
Depending on your situation, your lender may offer you a hardship variation to help you pay off your home loan without defaulting. You can also discuss your options with your mortgage broker to find the best course of action for your situation.
