With inflation and interest rates on the rise, lenders are increasingly scrutinising expenses such as home ownership when assessing borrower risks, reducing access to credit for many consumers and small businesses.
Home ownership has traditionally been seen as the great Australian dream and has traditionally be seen as a positive when underwriting unsecured consumer or small business credit. However, the risk off mentality in the current economic environment of rising inflation and rising interest rates is having a marked impact on a lenders view of risk and specifically how home ownership should be considered in a risk assessment.
Until recently homeownership was viewed favourably when individuals applied for a small business or consumer loan because the historic view was that they had the discipline to save for a deposit, qualify for a mortgage and purchase a home. In fact, many lenders would have two completely different credit matrices depending on whether a borrower was a homeowner or not.
However, with the changes we are now seeing in the market, depending on how recently a property was purchased, we are seeing that home ownership in today’s environment is being considered as a heightened risk indicator to the application as it may indicate a potential financial stress factor.
There are several factors contributing to this shift. The Reserve Bank of Australia (RBA) began increasing rates in May for the first time in two decades, with the cash rate now up by 1.75%, significantly increasing mortgage servicing costs especially for high price, high leverage housing assets.
This monetary tightening has come as a surprise to many borrowers, given the RBA had previously indicated its intent to keep rates at historical lows until 2024.
In addition, borrowers have often had fungibility between their personal and small business balance sheets. This means individuals are trying to service all their personal and business expenses out of their income and do not distinguish between the two. Therefore, the increase in personal mortgage expenses has directly reduced the amount of surplus available to support a business. When one then considers the inflationary pressures on the expenses of the individual and their businesses, without the potential pricing power to negate this, these individuals and small businesses find themselves in a perfect storm.
For example, a borrower who bought a $1.5m property with an interest only mortgage at an 80% LVR in December 2021, will now have more than $1,700 of interest servicing cost each month on their mortgage.
By comparison, this monthly amount is broadly equivalent to the total servicing cost of a $50,000 small business loan payable over 36 months – a common product offered in the market. This is only based on rate increases to date and does not account for the future rate increases that are expected.
Non-bank lenders face tougher conditions
Many non-bank lenders are now facing the most challenging market conditions they have experienced so far.
They entered the market after the Global Financial Crisis and financial services Royal Commission in Australia, when traditional banks retreated to their core competencies – lending to large corporates and offering secured finance to consumers and small businesses. This opened an opportunity for non-bank players to fill a gap in the market by offering non-mortgage-backed consumer and small business lending.
These newcomers have secured their place in the market by using innovative distribution models such as Buy Now Pay Later and credit models such as bank account scraping to assess risk.
Until recently non-bank lenders have enjoyed a relatively easy operating environment facilitated by low interest rates, sound economic growth and a high level of Government support for the economy during the pandemic.
Unemployment remains low, and defaults and arrears are still within manageable levels (pre covid equivalents or better), but the horizon looks very choppy and non-bank lenders are facing a much more uncertain outlook.
Lenders reassess their strategy
In addition to providing flexible funding to non-bank lenders, we work with non-bank lenders to understand their specific requirements and provide proactive advice to enable them to grow – a model we call ‘Value Added Credit’. We are currently seeing non-banks undertake a range of measures to adapt to the changed operating conditions. Serviceability has become a much more important focus in the era of rising inflation.
We are seeing more lenders enquire about home ownership and when the potential borrower acquired their home. If a home was recently purchased, they are requesting a full mortgage statement to validate the amount of debt.
In addition, where lenders are depending on the borrower’s equity value in the home as part of their assessment, many are using 2020 valuations rather than current ones to account for the expected fall in property prices.
We are also seeing lenders pay closer attention to the type of sectors they lend to. For instance, we are currently working with a client that specialises in lending to small businesses, often including franchise businesses. This lender is currently repositioning its loan portfolio from lending to consumer discretionary sectors such as gyms to focus on more resilient sectors such as quick service restaurants. There is a general nervousness of lending into the construction sector, especially after the larger bankruptcies.
Lenders are also looking at whether these small to medium sized businesses are price makers or price takers. A construction business that is exposed to rising input costs, for example but earns revenue from historical fixed price contracts, would be seen as a greater risk than a business that can set its own prices and pass on rising costs to customers.
Looking forward, with inflation still a concern and predictions that the cost of funding will continue to rise for the foreseeable future, we expect non-bank lenders to remain cautious.
Lenders are reassessing their loan portfolios, increasing their focus on risk, and tightening their belts to put themselves in an optimal position to weather any stormy seas.
Authored by Henry Stewart (Director, GCI)