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Here’s what you need to know about banks’ secret mortgage test rate

OPINION: Convincing a bank to give you a mortgage to buy a house is complex enough in normal times.

Sometimes the hoops you have to jump through to satisfy their criteria seem endless: get a builder’s report, a valuation, a LIM, a list iof income and expenses, proof of employment, credit history, accessing KiwiSaver, perhaps even guarantors.

It’s about making sure you don’t over commit yourself, and it’s likely to get tougher for some over the next month or so as the second tranche of wage subsidies expires along with mortgage holidays.

Even if the Reserve Bank extends the payment deferrals scheme (and remember it’s just a deferral – interest still accumulates), there’s no doubt that the banks will be looking very, very carefully at lending. Mortgage advisers are already reporting that loan applications that would have been granted before the lockdown are becoming much harder to get accepted, even those below the 80 per cent loan-to-value ratio.

 This is no criticism of the banks – they also have to ensure they don’t allow you to fall into hardship. It’s just the environment we’re now in, with uncertainty surrounding the economy, jobs and the global environment.

So what are the keys to getting a mortgage?

Actually, nothing much has changed. The ability to service a loan is vital, but rather than the emphasis being on actual income and expenses, it’s shifted to debt and ability to service in the event of an adverse event.

The son of a friend of mine recently started looking to apply for a loan to buy his first house. He and his wife worked out their joint income and their expenses and fed it into their bank’s online mortgage calculator, and it all looked good. As long as they stuck strictly to their budget, the repayments wouldn’t be a problem, and as they headed for their meeting at the bank they were already envisaging themselves in their house.

But they were to be disappointed – at least at that meeting.

What they hadn’t counted on was their level of debt and something called “unencumbered income”. Basically that’s money or capacity left over to service the mortgage repayments if things turn pear-shaped. If, say, one of them lost their job.

This couple might have been able to afford the repayments now, while interest rates are at historical lows, but what would happen if they increased? That’s the big question the banks ask.

The last thing they want is for you to be in a position where you can’t pay back the mortgage.

That’s why they perform a “stress-test” on your application, to see if you can afford to continue paying back the mortgage at a much higher interest rate. It’s something many mortgage-seekers haven’t heard of, but it plays a huge part in a bank’s decision-making.

This test is done on principal and interest payments over a 30-year term at whatever their servicing rate is, typically between 6 per cent and 7 per cent. So, while the mortgage calculator might show you can comfortably afford repayments on a $500,000 loan at 3.5 per cent, how will you perform at double that rate?

It’s something people should be aware of before they approach their bank.

The good news is that, despite the present tough economically challenging times, some banks are now moving to reduce their stress-test rate, meaning savings of several hundred dollars a month in repayments in their calculations, depending on the size of the mortgage and the stress rate.

Of course, there are ways of helping to ensure you can pass the stress test before you arrive at the bank.

One is to get a handle on your credit cards and hire-purchase. Paying down that debt as far as you can is good, but elimination is better.

Instead of taking your loan out for 25 years, make it 30 years. That will reduce your repayments and give you more unencumbered income. Another trick is to roll any other personal loans or hire-purchase into your mortgage, freeing up even more income, in the short term at least.

Whatever you do, I always advise people to seek independent advice. Mortgage advisers have experience and a multitude of options available to them, and they’ve seen it all before. To house buyers, particularly first-timers, they’re worth their weight in gold.

Katrina Shanks is chief executive of Financial Advice New Zealand

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