NZ Banks Lift the Interest Rates Used to Assess Mortgage Applications

Joseph Darby

Mortgage Applications Just Got Harder

Convincing a bank to give you a mortgage to buy a house is complex enough in normal times, let alone in an environment of rising interest and inflation rates. This means for some, the mortgage application process is about to get a lot tougher.

It’s little surprise that two of NZ’s largest banks have increased their servicing rates for mortgages over the last couple of weeks, in effect making it harder for Kiwis to get a mortgage. Other banks are expected to follow-suit, though many of them don’t transparently confirm where their test rates are set

This is unlikely to be the last round of increases and, despite what you may think, that is probably a good thing. Read on to find out why.

What Are Servicing Rates?

You might hear various names which usually all mean the same thing:

• Service sensitivity rate/margin

• Stress test rate

• Test rate

• Servicing rate

To explain, last year you could have fixed a mortgage for as low as 2.1% for one year or in some cases 2.99% for five years. If you’d done that, it might have been overoptimistic to think that interest rates would stay that low forever.

To cater for this, when banks assess mortgage applications, they calculate the borrowers ability to afford to keep repaying a mortgage at a much higher rate. This time last year, the mortgage servicing rate was around 5%; now it’s hovering around 7-7.5%. In other words, with servicing rates, the banks are confirming you can afford to pay a much higher interest rate, not what you can afford today. This is required as responsible lenders.

First Home Buyer Frustration

Servicing rates can be a source of frustration for home-buyers. A question we are often asked is why can’t the banks just use the five-year rate? Five years is a long time, and you’ll have plenty of warning to prepare for higher rates. Consider those people that locked in at 2.99% for five years. They have four years left to figure out how to deal with a higher interest rate environment, and probably higher mortgage repayments as a result.

The answer to why banks don’t use the five-year rate is in how fast mortgages are paid off over principal and interest loans.

For example, a $1m mortgage (for simplicity of maths) still has around $912,267 owing after five years of repayments have been made over a 30-year term. That’s because at the beginning of the mortgage, most repayments are made up of interest with comparatively little going towards the principal (debt). After many years of repayments, the principal payments increase and you pay off more each month or fortnight, but in those first few years, it’s mostly interest.

Even by your 15th year or repayments, halfway through your 30-year mortgage, you still owe $664,000 of the original million. So, when banks are trying to calculate what the worst-case scenario is, they’re having to look 10 or 15 years down the track before the amount that you have paid off your mortgage could counterbalance the potential increase in interest rates.

Hard to Swallow

Servicing rates will always be higher than the interest rate at any given time because no bank can ever guarantee we are at peak of interest rates.

If interest rates continue to rise over the next few years, more income will be needed to get the same level of borrowing.

So, if you had a mortgage pre-approved prior to this week, how much has your borrowing dropped when this pre approval is renewed given the increase in servicing requirements?

The truth is, about 4.5%. In other words, if you were approved for a maximum loan of a million dollars a few weeks ago, your new lending will be around $955,000. To get back to those million dollars of mortgage lending, you will need to increase your income by approximately $300 after tax per month.

The Bottom Line: Are Increased Service Rates a Good Thing?

While it might be tough to stomach for many buyers, increased protections are a good thing overall. They help protect the overall health of the economy, banking system, and property market.

It ensures that people who borrow such large sums of money are protected from the majority of future interest rate rises (which most commentators now expect), at least until they have paid off a significant amount of their mortgage. Imagine what a mess the property market would be in today if banks had calculated what people could borrow at last year’s historically low-interest rates, rather than the 5% they were previously using as a stress test.

If you’d like to speak with one of our mortgage advisers (mortgage brokers) about anything above, or about anything related to your current mortgage, it’d be our pleasure to assist. Simply get in touch.