Could waiting to refinance turn you into a Mortgage Prisoner?

Is your home loan interest rate leaving you feeling like someone has locked you up and thrown away the key?

With mortgage rates on the rise across Australia, the property market is shifting, and the way that lenders test your ability to service a mortgage is being calculated at a higher rate. This means that your ability to refinance your home loan could become harder, potentially turning you into a mortgage prisoner.

Mortgage prison is a colloquial way to describe when a homeowner wanting to refinance is no longer able to pass the serviceability test of a new home loan, leaving the homeowner locked with their current lender and unable to “escape”.

 

Generally speaking, you may find yourself in mortgage prison and unable to refinance due to:

  • Not meeting the new provider’s serviceability criteria (e.g. you can’t afford higher rates)
  • Not having enough equity in the home
  • The property falling in value below the mortgage balance
  • Being in a worse-off financial position (income loss, partner separation etc.)

 

In the current market, home loan interest rates are on the rise, thanks to a series of hikes to the cash rate by the Reserve Bank of Australia. With experts not predicting interest rates to fall for at least two years (next year at the earliest), it’s likely that home loan interest rates will continue in their upward trajectory.

When interest rates increase, it’s not uncommon for homeowners to look for strategies to give their budget some breathing room, including refinancing. Especially if you’re one of the lucky homeowners that fixed your interest rate before the latest cash rate hikes, and are looking at the current market and wondering how you can avoid a significant increase to your repayments when the fixed period ends.

The risk is: for those considering refinancing, the window of opportunity could be closing.

 

Mortgage prison: why refinancing could become more difficult

If you have done your research and are strongly considering refinancing, it’s important to understand how rising interest rates could affect your application and increase your chance of being a mortgage prisoner in the current environment.

Mortgage prison: why refinancing could become more difficult

Buffer rates on the rise

When interest rates are rising as a result of the cash rate being lifted, the buffer rate that lenders use to test a borrower’s ability to service a loan is often increased in tandem.

Typically, when you apply for a home loan, a lender will test your ability to meet repayments based on their current standard variable rate, plus a buffer of around 2-3% higher. This is because it is expected that your rates will fluctuate over a 20-30-year loan term, and the lender needs to determine that you can comfortably repay the mortgage at a higher rate.

For example, before the 2022 cash rate hikes, a hypothetical lender may have tested a borrower’s ability to repay a home loan on its variable rate of 2.00%, plus a buffer of 2.50%, equalling 4.50%. Now that rates are higher, it may be testing your income on a variable rate of 3.50%, plus a buffer rate of 3.00%, so your ability to service a mortgage is now assessed based on a rate of 6.50%. On a hypothetical 25-year, $500,000 home loan, that’s a difference of $2,779 versus $3,376 in monthly repayments.

Not only do higher rates mean that you’re paying more for your current mortgage, but if you want to refinance, a lender is assessing your application with harder criteria. If your household income has not increased since you took out your home loan, you may find that a new home loan lender could reject your loan application, as it does not believe you can responsibly service the loan based on the buffer rate serviceability test.

To personally test whether you can comfortably meet home loan repayments based on a higher interest rate, it may be worth using a Mortgage Repayment Calculator. Simply enter in your current home loan balance, loan term, as well as the refinancing rate you’re interested in – plus a buffer of at least 2-3%. This may indicate whether you are already a mortgage prisoner or not.

 

Property prices are falling

Another side effect of rising interest rates is that it can put downward pressure on the housing market and property prices, as access to credit is made more difficult for borrowers. The latest CoreLogic Home Value Index recorded a fourth consecutive month of national property value declines, falling 1.6% in August alone – the greatest month-on-month decline since 1983. While this might bring real estate relief to first home buyers, Australians who purchased their homes in the last year or two may find that the property’s value has actually decreased.

When your property’s value decreases, and you’ve not had the time to build up equity with home loan repayments, there is a chance your loan-to-value ratio (LVR) could creep higher. If your loan to value ratio increases above a lender’s preferred range (generally 80%-90% LVR or less), you may be less likely to be approved by a new lender to refinance your home loan.

Or, if you were approved for a new loan but your LVR is now below 80%, you run the risk of now having to pay costly Lender’s Mortgage Insurance (LMI). This can easily climb into the tens of thousands of dollars range, depending on the value of the property – making refinancing even more expensive.

Further, when property prices are falling, you run the additional risk of your home entering negative equity. This is where the outstanding mortgage balance is now greater than the value of the property itself.

The impacts of this can be twofold: you are likely unable to find a lender willing to approve your refinance, or if you cannot afford to repay your home loan and you risk default, the value you’d earn from selling the property would not be enough to cover the cost of the mortgage. You would be without a home and likely still in debt to the bank – keeping you in a different type of mortgage prison altogether.

Property prices are falling

Is waiting to refinance going to make you a mortgage prisoner?

Without a crystal ball it’s difficult to predict a perfect time to refinance. That being said, homeowners can take stock of market conditions – such as rising inflation, higher interest rates, lower wage growth and rising property prices – and make an educated assessment as to whether they should consider applying to refinance before rates climb any higher.

The RBA has already stated it will likely continue to take “further steps in the process of normalising monetary conditions” over the months ahead – which simply suggests it will keep raising the cash rate for some time. This means that the factors, listed above, that may put a homeowner into mortgage prison could become more widespread, as rates likely will continue to increase. This could result in more Australians being unable to refinance out of their high interest rates and mortgage repayments.

It’s hard to say definitively how every individual homeowner will be affected, as each financial situation is different. However, if you are considering refinancing but are:

  1. already seeing house prices fall in your area, and/or
  2. have tested your repayments with a higher buffer rate and it’s close to unserviceable,

then it could be worth making the switch before interest rates rise further, refinancing becomes more challenging, and you find yourself in mortgage prison.

 

How to refinance your home loan

If you’ve assessed the pros and cons of refinancing and determined that it is the best decision for your situation and budget, it’s now time to begin the refinancing process. Refinancing does not happen overnight, so if time is of the essence for you, it’s worth being realistic about the general timeline of refinancing.

How to refinance your home loan

The process of refinancing your home loan

 

1. Research – 1 hour to 1 day

Take time to research different home loan options for one that best suits your refinancing goals. For example, if a lower interest rate is your goal, the competitive Reduce Home Loans Economizer Variable 80 at a rate of 3.58% may be worth considering.

2. Qualification – 2-3 hours if healthy (or however long it takes to improve your finances)

Look at your financial health and situation, including your credit score, and whether you could afford a higher buffer rate in the serviceability test of a new loan. You’ll want to be in the best financial position to boost your chances of approval. At this point, hopefully you will not already be in mortgage prison.

3. Documentation – 1-3 hours

Collate all your documentation, including personal information to make the application process easier.

4. Application – 15 minutes to 1 hour

The refinance application can be submitted in branch or online, depending on the lender.

5. Valuation – 2-3 business days

Your property’s value will be assessed by the new lender before approving the refinancing loan. If your property value has not fallen so much that you’re in mortgage prison, this should only take a few business days.

6. Approval – 2 business days to 2 weeks

Full refinance approval could take anywhere from a few business days up to 2 weeks, depending on the lender.

7. Settlement – 2 to 3 weeks

Your existing home loan lender will transfer the property title, and debt, to your new lender. You will have officially refinanced your home loan and escaped the chances of being in mortgage prison.

Mortgage Prisoner

What if refinancing is no longer an option?

There are other ways that mortgage holders can potentially give themselves some breathing room in their budget for home loan repayments, if refinancing is no longer an option. You may also want to consider the following options

Making extra repayments – Any extra cash or lump sum amounts you can make as additional repayments to the loan could chip away at the principal owing, helping to boost your equity and reduce your repayments.

Using your features – If the loan comes with an offset account or a redraw facility, the funds you deposit into your offset, or that go into the redraw, can work to reduce the interest charged on the loan. For example, if you have a $500,000 home loan and deposit $50,000 into an offset account, you will be charged interest as if the loan balance is actually $450,000.

 

No homeowner wants to find themselves locked up in mortgage prison. If you’ve considered your options carefully and want to refinance your home loan, or are just looking for more expert information, speak to the team at Reduce Home Loans today.

 

Any statements are general in nature and do not take into account your financial personal situation, objectives or needs. You should consider whether any statement/s is suitable for you and your personal circumstances. Before making any financial decision, consider your circumstances and the product disclosure statement.

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