Looser lending has downsides

Paul Clitheroe.
Paul Clitheroe.

BANKS are relaxing their lending limits, and while it's a move that may be welcomed by first home buyers, I'm not convinced that being able to borrow more is always a good thing.

Research by comparison site Rate City shows that around 70% of today's home loans require a deposit of just 5%. Put differently, it means that with savings of just $25,000 you could potentially buy a home worth $500,000.

Two years ago, when we were still reeling from the global financial crisis (GFC), only around one in two banks offered loan limits this generous.

Indeed prior to the GFC, 'no deposit' loans were very popular. In some cases borrowers could borrow up to 105% of their property's value with the option to tack buying costs like stamp duty onto the loan. These loans have since gone the way of the dinosaur, and I don't expect to see them return any time soon.

Today's increasingly generous lending limits may sound promising for first home buyers with a small deposit, however borrowing a bigger proportion of your home's value comes with a raft of downsides.

Foremost among the pitfalls is the prospect of paying lenders mortgage insurance (LMI).  This protects the lender, not you, in the event that you cannot meet your loan repayments, and it is something most lenders will insist on if you borrow 80% or more of your home's value. For the home buyer, it is nothing more than another cost to contend with for getting your own roof over your head.

The thing is, LMI can cost far more than many people realise. As a guide, if you have a deposit of $20,000 and you want to borrow $380,000 to purchase a $400,000 home (in other words you have a 5% deposit) the LMI premium could come to around $11,500. That's over half the value of your deposit! In fact, using this example, you would need a deposit of at least $81,000 to avoid LMI altogether.

Another example - LMI on a $570,000 loan for a $600,000 property is nearly $24,000. That's very serious money!
Some lenders will let you add the LMI premium onto your loan (known as 'capitalising' the cost). This means you are paying interest on the premium, which inflates the expense even further.

If you are interested in knowing what you could be up for in lenders mortgage insurance, search it online and you will find a few calculators.

There are other downsides associated with borrowing a high proportion of your home's value. It means taking on a bigger loan, and that means paying more in monthly repayments - and overall interest charges. It also means you are at greater risk of struggling with your loan if your work hours are cut back, an unexpected expense crops up, or you or your partner face unemployment. I don't want to sound like a doomsayer, especially as I am a fan of home ownership, but you need to consider these possibilities and have a plan for meeting your mortgage repayments if and when they occur.

Remember too, saving a more substantial deposit will leave you better placed to comfortably pay off your home - especially if, or rather when, interest rates rise.

Today's property market may be showing signs of a modest recovery though it remains a buyer's market in many parts of the country. This means many buyers have no compelling excuse to rush into the market - and plenty of sensible reasons to focus on growing a decent deposit.

Paul Clitheroe is a founding director of financial planning firm ipac, chairman of the Australian Government Financial Literacy Board and chief commentator for Money magazine. Visit www.paulsmoney.com.au for more information.

Topics:  banks, interest rates, lending, lending limits, prudential supervision



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