Negative Equity in Housing and Homeowners Protection

Money
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Philip Lowe, The Governor of The Reserve Bank of Australia, says that only five percent of homeowners are in negative equity (owing more to their lenders that the current market value of their homes), see here: https://www.propertyobserver.com.au/financing/loans-and-mortgages/96179-only-5-of-homes-in-negative-equity-says-rba.html

I believe that in the run-up to this Federal Election all political parties should have as part of their policy platforms that homeowners in negative equity will have their right of access to future fixed rate housing loans to cap their housing loans repayments when interest rates start to go up. The reason for this is that these homeowners are normally on tight budgets and cannot afford repayment increases without experiencing mortgage stress. They could readily lose their homes if they are denied access to fixed rate housing loans.

The issue that could cause this scenario to happen is that fixed rate housing loans have a break cost and in the case of a loan default the banks would have to absorb this cost. Homeowners in negative equity are considered a higher risk. Choice needs to advocate for these homeowners to be protected by requiring banks and other lenders to guarantee access to fixed rate housing loans without penaltyin the case of future of variable interest rate housing loan increases.

This is a real and present danger for a large number of Australian families that is readily foreseeable and preventable by Choice advocating to protect these vulnerable families.

This is what happened in the United Kingdom where they had wide spread negative equity: https://www.moneyadviceservice.org.uk/en/articles/negative-equity-what-it-means-and-what-you-can-do-about-it. We should not repeat this mistake.

What do other Choice Community Followers think?

Regards

John Cosstick

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Don’t they already have that right to fix loan repayments? It is possible to have loans fixed for periods of 10 years (and more?)

If anyone is in negative equity and is concerned about ability to afford repayments should interest rates go up, possibly they should seek independent advice to see whether a fixed mortgage rate is for them. It is worth noting that fixed rates could be higher than current variable rates as the fixed rate takes into consideration likely future interest rates.

I wonder if the question is about interest only loans and principal and interest loans. Many of the interest only loans are coming to the end of their terms and most financial institutions will revert back to PI loans which incur higher monthly repayments.

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The issue is the same as what happened in the United Kingdom. Anyone applying for a fixed rate housing loan when in negative equity is likely to get this response:
"Most lenders will not let people with negative equity switch to a new mortgage deal when their existing one ends.

Instead, they will normally be moved onto the lender’s standard variable rate."
This can be seen here :https://www.moneyadviceservice.org.uk/en/articles/negative-equity-what-it-means-and-what-you-can-do-about-it

Many homeowners may not be aware of their negative equity positions until it is too late. It is highly unlikely that banks will allow a homeowner to switch to a fixed rate housing loan when they are in negative equity because of their greater risk of not being able to cover the break cost of a fixed rate housing loans.

You are right about fixed rate housing loans generally being at a higher interest rate for a fixed term. It is also why a switch point calculator approach to risk management relating to a borrower’s budget is the correct approach to preventing borrowers getting into mortgage stress; this issue has been well known to the financial planning community for many years. This service is, in fact, what mortgage brokers should be receiving trailing commission for as a service.

Mortgage brokers and financial planners should be working together to help clients, but we have not realized that we have created silos instead of focusing on the clients’ needs. This is why the United Kingdom now has transitioned to a single financial guidance body which can be visiting by googling it. (there is a limit on links in a post)

This is going to be a painful lesson for Australia in not learning what happened overseas. It is why political parties need to protect consumers. They do not seem to have noticed what happened here https://www.theguardian.com/australia-news/2017/may/12/theyve-lost-the-lot-how-the-australian-mining-boom-blew-up-in-property-owners-faces. This disaster was about negative equity.

Thanks for the comment and helping with the discussion. It is an important issue that overseas experience has shown.

Regards

John Cosstick

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If the fixed interest loan you propose moving people to relieves their repayment stress it must be lower interest than they would otherwise be paying. So they are getting a loan at more favourable conditions than the prevailing market. Who is going to pay the difference? Surely you don’t imagine the lenders would just suck it up and lose money. If you are proposing a government subsidy what would it cost?

I am cautious about making special financial deals for some categories of people without knowing all the consequences. Do you have any information that might tell us what such a policy might do to the market? We already have well meaning policies that have unintended consequences such as the first home owners scheme that is supposed to help young people into home ownership but also adds more fuel to overheated markets and so makes it harder for them.

Is it possible that such legislation would create another opportunity for rent seeking? We already have too many of those in our society.

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There is no alteration to the existing market only better risk management by linking the ability of a borrower to pay increased hosing loan repayments to their budget as to when to fix their interest rate. It is making home loans have a higher duty of care as a financial product as called for by Mike Taylor, the editor of Money Management in this article: https://www.moneymanagement.com.au/news/financial-planning/mortgages-are-financial-products-and-need-advice.

This is not a special deal it is only a systemic change to a higher duty of care and the need for advice. The banks and the financial planning community are fully aware of this and have been for many years. The financial counselling community services would not be required so often if this was put in place.

From a negative equity perspective, the danger of negative equity exists because a factor to cover borrower’s mortgagee sale shortfall was not included in the structure of loans. The lender’s mortgage insurance is usually paid up front and often added to the amount of the loan. This has escaped the notice of Choice and the Royal Commission. I believe that the United States 30 years fixed rate housing loans have a factor to cover break costs in case of prepayment included in the loan repayments. You can check this if you wish, but I believe that it is correct.

This is the reason that Choice should have a place on any body considering systemic changes resulting from the Banking Royal Commission.

Thanks for contribution to this important discussion.

Best wishes.

John Cosstick

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Interesting question John.

What has led these people to have negative equity? Was it that they bought badly and paid too much for their home, was it that they bought at the wrong time in the housing cycle, did they buy off the plan only to find their home was overpriced, or did they build on a natural flood plain that flooded, etc. Alternatively was it something out of their control such as a weather event that reduced the value of their land, or is a highway being built next door, or
 ???

Should they be protected because when didn’t do their due diligence? Should they be protected when all they thought about was the profit to be made if they bought in? Should they be protected because they bought at the top of the market? etc.

Also consider that just because they have negative equity now doesn’t mean that it will stay that way long term. Perhaps the markets they are in will return to growth? Do they need to repay their concessions if that happens? i remember repaying my mortgage during the 1980s interest rate boom. The interest rate went up every month. Many people ended up with negative value. It only mattered if they wanted to sell their homes. The ones that stayed put were able to recover and after a time their home values grew again.

I think your suggestion would lead to more speculative purchasing because buyers will feel that they will be cushioned if their market value tanks.

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Just wondering if there is any evidence of this in Australia. I can imagine that it would be challenging to swtich lenders, but most lenders with higher risk loans, such as those where the property is in negative equity, the lender will try to mitigate their risk
if there is concern about the long term ability of the mortgagee to finance the loan. In such cases this could be done by pushing up interest rates on the loan or another way could be to move all or pastprt of the loan to fixed term/fixed interest rates based on what can be afforded by the mortgagee. Another is to extend the term of the loan which reduces the principal component of the repayments, but increases overall interest paid over the life of the loan.

Switching to fixed term/fixed interest loan ensures that the mortgagee has a stable level of repayment which can be better managed, especially if interest rates do move upwards (there are many economists talking at the moment that the next interest rate move would be south later in the year due to reduction in house prices).

It would be interesting to get response of Australia’s financial and banking institutions to see what their views are on negative equity loans on their books and how they manage such loans where there is a risk of default (which wont be all NE loans). Such would be good to know rather than what has occurred in another country. Each countries financial systems are different, as well as how they manage risks.

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Thanks for the reply Meltam. I think that a market correction is well and truly underway. The average homeowner needs to be made aware of what it means and what they can do about it. It is also why Choice should be represented on any body considering systemic changes that should be put in place to better protect consumers. There are clear lessons that should have been learnt from the UK experience. Google moneyadviceservice.org.uk - negative equity- what it means and what you can do about it.
Meltam, I don’t think that this is being over protective of consumers I think that it is better risk management systems. It is important to remember that lender’s mortgage insurance protects the banks in case of a shortfall in case of a default and mortgagee’s auction. There is no reason that borrower’s mortgage insurance could not be a part of the structure of a housing loan to cover the borrower up to the level of the debt. It is a more equitable system as is the better interest rate risk management by making housing loans a financial product as proposed by Mike Taylor, the editor of Money Management. Consider the situation if there was a $500,000 loan with a term of 30 years (Principal and Interest) and risk was proactively managed so that the interest rate was decreased by an average of 2% of the term of the loan. It is worth working out! The rolling average standard variable interest rate loan rate over the past 60 years is 8.3% p.a. (I am going from memory, but I believe that is correct)

Mike Taylor is a clever man with a lot of experience and I think that he is right, home loans should be a financial product for this reason.

Thank you for contributing to the conversation.

Regards

John Cosstick

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John you didn’t reply to any of my questions.

Who pays for the scheme?

What evidence do you have that there will be no effect on the market? Prima facie any change in the rules potentially will have some effect. We already have interventions that do, so why will this one not?

Why will this not encourage rent seeking?

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Hi Syncretic, there should be no payment for the scheme because it is only treating the consumers more equitably. All banks , for example, lend to clients either directly through their branch networks, brokers or as aggregators. The financial planners have to comply with their duty of care as set down by ASIC but they are within the one organization and there should not be two duties of care in my opinion. I will be very surprised if this is challenged in court as it is a case of silos having developed to the detriment of consumers. Mike Taylor’s recommendation that home loans should be a financial product is in my opinion correct, but it is not a market intervention in my opinion it is applying what should be in the Banking Code of Practice. If it does not cover this situation it is excellent example why Australian Consumers’ Association should have been involved in its review and redrafting.

In regards to rent seeking, checked out Investopedia and this what it says " How Rent-seeking Works

Rent-seeking occurs when an individual or business attempts to make money from its resources without using those resources to benefit to society or generate wealth. One of the most common ways companies engage in rent-seeking is by using their capital to influence politicians. Politicians decide the laws and regulations that govern industry and how government subsidies are to be distributed. If a company succeeds in receiving subsidies or in getting laws passed that restrict competition and create new barriers to entry for an industry, it has increased its share of existing wealth without increasing the total of that wealth. Moreover, it has earned income without being productive or putting its capital at risk."

It would appear to me that Mike Taylor understood this very well and was, in fact, the reason for his recommendation.

Thank you for the discussion.

Regards

John Cosstick

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Hi phb, Yes, I too would be interested in seeing what a response would be if the question was raised with a market monitor. I will put it to finder.com.au and let you know. However, I think it is a question that should be put to political parties by the Australian Consumers Association ahead of the elections because that it how you would get some commitment to action and protection of consumers. An opportunity like this comes along very rarely.

Thank you for the contribution.

Regards

John Cosstick

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Who absorbs the difference between the market rate and the reduced rate of interest that you propose? If there is no difference then how do the beneficiaries of the scheme save any money?

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Hi Syncretic,

That was quick! It is not a reduced rate of interest, it is only a systemic change in risk management that tells the consumers when they should switch from a variable interest rate loan to a fixed interest rate loan that relates to their budget to prevent mortgage stress - both are market rates. The difficult part about it is that fixed interest rate loans are generally higher than variable interest rate loans and borrowers are loathe to switch to a fixed interest rate loan because it increases their repayments. They are easily caught in a spiral of increasing repayments and often will finish up as clients of financial counselors. This is well known to the innovation and fintech community and you can see my article about it here https://www.innovationexcellence.com/blog/2018/04/06/what-innovations-are-needed-for-better-mortgage-interest-rate-management/. This article shows Andy Haldane’s graph on the 5,000 year history of interest rates which highlights just how unusual the current market is. It also emphasizes the importance of Mike Taylor’s view that home loans should be a financial product. The market is quite tricky for consumers with wages stagnating and especially for those on a tight budget. They can easily be in mortgage stress.

This is not a scheme as such it is what banks should be doing under the Banking Code of Practice. If a consumer proactively manages their risk relating to their budget they will avoid mortgage stress. It is why the United States 30 year fixed rate housing loan with no break costs (because a premium to cover it is included) is so popular with consumers.

There is intriguing times ahead for Australia in 2019 and beyond.

Regards

John Cosstick

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This may fall into reading the glass ball
if one could predict the best time to do anything, one could make a lot of money very quickly.

Even today, if one sees economic forecasts for say Australia, these range from being positive (optimistic) to negative (pessimistic). If one accepts the positive economic forecast, this could have have upward pressure on interest rates (which has historically been the case but more recently patterns have deviated from historical trends). It could therefore be argued that one should lock in interest rates. What happens if the pessimistic economic forecast eventuates, it is likely that the mortgagee has paid a higher interest rate and unnecessarily increased their risk of mortgage stress.

The alternative scenario also exists where one accepts a pessimistic view, but the optimistic forecast eventuates.

The above only assumes to scenarios. In reality, there will be a spread of forecast from the highly optimistic to highly pessimistic. Which one does one accept and use for providing advice to a mortgagee?

It would be brave financial institution that instructs its negative equity mortgagees to lock in fixed interest rates based on future economic forecasting
and if they do and it doesn’t work out in favour of the mortgagee, who would be liable. The legal profession would have a field day and possibly be the ultimate and only winners.

What may be better is bank customers (irrespective of their equity positions) are advised of their options in relation to the long term financing of their mortgages. This information including information like value of repayments for various options would allow the mortgage holder to make decisions they believe is in their best interests
or to take a punt/accept risk in relation to future mortgage arrangements.

It is worth noting that such is available currently through financial institutions and includes the mandated comparison rates to allow one to compare between institutions. One can also receive the information in relation to their own circumstances if a request of made of the financial institution.

I am not sure if financial institution ‘selling’ alternatives based on economic forecasts will be in the interests of the customer or possibly the bank.

If a bank for example knows they are about to increase an interest rate, they shouldn’t be telling one consumer group to reconsider their financial position. This unfairly favours one group over another and is akin to insider trading.

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Hi phb.

You miss the point. In the current market or at any time it is not the forecast of the future interest rate movements that determines the individual risk profile of the client, it is their budget and what they can afford to increase their payments to. It is a method of risk management just as a financial planner will make an assessment of the risk of a client for investments.

Nevertheless, I do think that Andy Haldane is right about the level of interest rates globally. He has the resources as the Chief Economist of the Bank of England far more so than we have. What he says is also borne out by this list of Central Bank interest rates : https://en.wikipedia.org/wiki/List_of_countries_by_central_bank_interest_rates. We are rapidly approaching the interest rates levels of some European countries e.g. Eurozone, but not Switzerland I hope.

This is the reason why the 30 year fixed interest rate housing loans in the United States are favoured by consumers. It is the certainty that it gives their budget.

The Eurozone for example is now in a difficult position. I hope this clarifies that it isn’t forecasting. It is the risk tolerance of the consumer and their budget.

Banks have made a lot of money using the current system.

Regards

John Cosstick

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You possibly have answered your own problem with this statement.

If one has a loan they can afford, then negative or positive equity becomes irrelevant. Many years ago there were caps on % total income which was used as loan repayments based on a notional higher interest rate (say 10%). This was used to back calculate the maximum loan amount which could be provided to the borrower.

If someone can’t afford a loan because the interest rates return to normal levels (6-7%), then either the lending institution didn’t follow responsible lending practices or the mortgagee is living beyond ther means due ro their other financial obligations or lifestyle choices. Other financial obligations could include maxing out a credit card which assessment is somewhat removed from the mortgage repayment requirements (it is based on capacity to repay a credit card debit not necessarily based on affordability).

30 year terms are possible in Australia but risky for the mortgage holder as they are most likely to pay considerably more than shorter fixed term or variable/fixed portions.

The difficulty with 30 year term is there can be significant penalties if a loan term is broken, including paying lost interest if interest rates at time of breaking are lower than the rate in the loan being broken. Thia amount can be significant and more so with longer loan terms.

Also, if ones financial situation changes, say has significant increase in take home income over tge 30 years, most fixed term loans don’t allow additional payments to facilitate the early discharge of the loan. Therefore the mortgage is locked into paying interest on the loan at a potentially higher interest rate for 30 years, rather than being able to make additional payments and discharge the loan earlier
saving considerable interest payments over the life of the loan.

I also understand that the US mortgage system is also very different to Australia whereby a mortgage can in effect hand back the keys to the financial institution if they can’t afford the loan or the property has negative equity and unlikely to become positive in the foreseeable future. In effect walking away from the property and loan. I am not sure if this is something we want in Australia.

The recent GFC was partly caused by US banking system as the instutions were not overly profitable had had limited capacity to cover bad/defaulting loans. Fortunately for Australia’s financial system, it is highly profitable and well capitalised which provides some buffer should there be a significant increase in bad loans here. I would prefer the situation here rather than having a financial system collapse which would affect everyone in Australia.

If interest rates do go down, individuals have a choice to either maintain pre-interest rate reduction repayments to provide a buffer/reduce their own loan risks or only pay the repayments based in the new lower interest rate.

When the later happens, it is seen as a financial windfall and the additional disposable income is spent. When interest rates then increase at some in the future, the pain is greater as one has to change their lifestyle to dind money to cover the additional ihterest payment. If one had foresight (and maybe common sense), this situation could very easily have been avoided.

This is a decision of the mortgage and they should (or should they?) be advised of the advantages/disadvantages. Maybe then the interest rates go down, a mortgage has to apply for the reduced interest repayments rather than it be an automatic adjustment by the bank. This wmay then force some to reconsider the potential windfall if the lending institution provided sufficient details at the time of the interest rate reduction to why it is recommended that repayments are maintained at the pre-interest reduction rate.

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The target group you speak of can already (in principle) access the option to go to fixed if they choose to do so. The benefit that you want to give those in negative equity is a guarantee of the right to do that. Facing a rising market when the lenders are factoring in higher rates at the reserve bank and variable loans this will lead to higher rates in fixed loans as they anticipate the rise. In this context the negative equity loan is a higher risk.

The lender can approach higher risk loans in one of two ways. They increase the rate compared with lesser risk loans or refuse the loan. Neither option fits your plan for a guarantee.

You want to do away with the right of lenders to deal with risk by legislating that negative equity loans are not higher risk.

You said " Choice needs to advocate for these homeowners to be protected by requiring banks and other lenders to guarantee access to fixed rate housing loans without penalty in the case of future of variable interest rate housing loan increases."

Assuming this could be enacted (which I doubt) lenders who cannot accede will just stop offering that class of loan. How will that help? Or do you intend to force them to make loans that they deem are poor value or bad risk?

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Hi php. There is two issues as I see it:

  1. Is improving the risk management of interest rates so that they relate to preventing mortgage stress of consumers. The current system is in my view inadequate in view of the high debt levels and low interest rates. It is not a predictor of markets, but as a service to customers. In the past the system could have been viewed as adequate. I believe that this is the warning that Andy Haldane was giving with his graph. Certainly the OECD’s stagnation of wages as a global issue was a warning that consumers were struggling, see here: http://www.oecd.org/newsroom/rising-employment-overshadowed-by-unprecedented-wage-stagnation.htm

  2. The second issue is that I think that mortgage protection insurance for borrowers needs to be included in the structure of home loans so that any shortfall at a mortgagee’s auction is covered up to the level of the debt. I believe that this will be challenged in the courts for past examples where there was widespread bankruptcies over this issue. Going forward, I believe that this system needs to change. The result will be Lender’s Mortgage Insurance paid up front by the borrower and Borrower’s Mortgage Insurance included as a premium in the structure over the term of the loan . I believe that this is a more equitable basis of risk management of negative equity risk.

The purpose of this discussion is to draw attention to this possibility as a position for the Consumers Association of Australia should they become involved in the remediation discussions for consumers and also system changes.

I recently saw the Certified Financial Planner who was in the team that wrote the examination questions for the certification of planners in 2004 when the problems started. He agrees that you can’t go back and change the past, but we can be smarter about planning for the future. It would be smart for the Australian Consumers Association to be involved in the future because mistakes were made and there are some very angry consumers who feel their interests were not fairly protected


Regards

John Cosstick

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Getting down to absolute basics about your idea to offer insurance to cover the loss if a person were to sell their home in a negative equity situation, how much would the premium be? Would any insurer be prepared to offer such insurance? But most importantly wouldn’t that cause people to sell their houses and make a loss because they wouldn’t be wearing such loss?

Insurance companies are in business to make a profit, to do that they normally add up all the claims and add their expenses and profit and divide it by the number of policies. I am sure as an ex-banker, ex-accountant and ex-financial planner you should be aware of that. So how much would the annual or even one off premium be? How many people are actually selling their properties and making a loss that would be claimable in the circumstances you are indicating?

I do believe that if people had such insurance they would not try to get the best deal in selling their house because if they were going to make a loss anyway, why would they care whether it was a little bit or a lot and then too comes the dishonest bit, why not sell your house cheap to someone you know? I don’t think that your idea is very practical.

And I agree with others who have said that people are able to get fixed interest rate loans now. Because most variable rates are lower and these people don’t have lots of money they go for the lowest rate. One would hope that after the Royal Commission banks and mortgage brokers and anyone else involved in housing loans would be including the amount of repayments if interest rates were to rise, say by 1/2, 1, 2 and even 3% and giving the weekly or monthly repayment amount. To me this is much more significant than a borrower getting into negative equity which really only affects them greatly if they need to sell and liquidate. Being in negative equity in the everyday situation doesn’t affect you much. Indeed I would think there could be many in that situation who don’t know and therefore don’t care. They just keep paying their house off and at some point they will reach positive equity.

I was wondering why you John Cosstick (Jack Taggerty) brought up this topic? I asked myself is he naive or does he find himself in a negative equity situation? When I checked you out and found you were a “freelance journalist” and an ex-financial planner, I thought you shouldn’t be naive. So I just don’t understand where you are coming from.

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HI FR Sampson, This is where I am coming from : https://www.moneyadviceservice.org.uk/en/articles/negative-equity-what-it-means-and-what-you-can-do-about-it. Once you have read it you will realize that hundreds of thousands of Australian young families deeply in debt and now in negative equity do in fact have a problem! The United Kingdom has introduced the single financial guidance body and related standards to help people in the United Kingdom that are trapped. You can read about it here: https://singlefinancialguidancebody.org.uk/.

This is a serious issue that has not been experienced like it has in major cities like the United States and the United Kingdom. It has been experienced in some regional areas substantially which can be checked out by googling “they’ve lost the lot” . To say these consumers are angry is an understatement. We need to fix problems that are systemic weaknesses and you fix them by telling the likes of the Consumers Association of Australia about them so that they can campaign for a consumer guide to be issued on Negative Equity. People need to understand this issue and what to do about it. We can then campaign for reforms.

The Money Advice Service of the UK government are right - negative equity is a serious issue and home owners can lose serious money if they do not get advice early.

After you have checked whether I am right or not let me know and we can chat some more if you wish.

Thank you for responding on this important issue.

Regards

John Cosstick

When you you checked out the background some more