The banking regulator will not relax loan serviceability buffers despite the prospect of some borrowers being trapped in a 'mortgage prison', unable to refinance their home loan.

While the Australian Prudential Regulation Authority is watching mortgage stress as hundreds of thousands of mortgages roll off low fixed rates to much higher variable rates, its chair John Lonsdale is standing by the current 3% serviceability buffer.

Lonsdale says the buffer is not creating a regulatory impediment to refinancing, which is at its highest level in two decades.

"Our view is no, we don't think that it is unduly impeding people's ability to switch," he told a Senate estimates hearing on Wednesday.

"On the serviceability buffer itself, we constantly look at it. We think that 3% is the right number."

There have been calls for APRA to relax the serviceability buffer, which requires lenders to stress test whether borrowers would still be able to meet their repayments on an interest rate at least three percentage points above the loan rate.

Refinancing spikes as fixed terms end

Lonsdale acknowledges some borrowers may face difficulty in refinancing their mortgage.

"We are attuned to concerns for some borrowers who may have fewer options for refinancing their existing loan with another lender, for what could be a variety of reasons.

"For some, the impact of rising interest rates may have resulted in less favourable serviceability results; others might be impacted by declining housing prices or changed personal finances."

But he says APRA believes the serviceability buffer level remains appropriate in the current environment, pointing to a weakening global economy, inflationary pressures and expected weakening in the labour market over the next 18 months.

Former Reserve Bank of Australia governor Ian Macfarlane is among those arguing APRA may need to reconsider the serviceability buffer as fixed-rate borrowers seek to refinance.

Mortgage cliff

The RBA estimates 880,000 fixed-rate loans worth $350 billion will roll off by the end of this year.

Macfarlane says the fixed-rate mortgage cliff is potentially a serious problem although he expects it will be resolved.

"The borrower is going to have to pay more … the bank's going to have to absorb some of that and quite possibly APRA's going to have to relax the rule," he told a recent podcast by Stanford Brown, where he is an investment committee member.

While most people refinance with their own bank, Lonsdale says about 1% of the total stock of loans change providers each month - the highest level in 20 years.

"So, people are refinancing, there looks to be competition there and they are switching where they can switch."

According to the RBA, about 880,000 fixed-rate loans amounting to about $350 billion in credit are set to roll off by the end of this year.

Borrowers who enjoyed record-low fixed rates during the pandemic face their mortgages moving from about 2-2.5% to a variable rate around 5.5-6.5%, after 11 hikes in the cash rate over the past year.

Banks are still lending to good borrowers who want to refinance but might fail the serviceability test, under an exception allowed by APRA.

"Where a bank has or sees a good customer that they might fail the serviceability test but if they look at their track record of payments they are a good borrower, then they can lend to them," Lonsdale says.

About 2% to 3% of loans are being written under the exception policy, he says.
Some lenders such as Westpac have lowered the stress test for select borrowers seeking to refinance their mortgage.

Mortgage cliff impact on banks

Morningstar banking analyst Nathan Zaia expects some fixed-rate borrowers will fall behind on their mortgage repayments as they move to higher interest rates, but notes banks are working hard to retain their customers.

"There is likely to be some fixed-rate borrowers falling into arrears as they move to current rates.

"But we don’t expect fixed-rate borrowers to default simply because they cannot refinance to another bank."

There continues to be intense competition in mortgages and deposits, and switching activity is elevated.

"What we have seen, and we expect will continue, is lenders are offering borrowers a competitive offer regardless of how easy they would have been able to switch to another bank," Zaia says.

"In a competitive environment, banks are focused on holding onto market share, and not doing the right thing by borrowers could impact goodwill and the relationship with customers and brokers, and potentially bring unwanted attention from government and regulators."

While bad debts at the major banks remain very low, Morningstar expects there will be a material rise over the next 12 months, but nowhere near as bad as during the global financial crisis.

Shares in ANZ, Westpac and National Australia Bank are currently trading at a discount to Morningstar's fair value estimates, while Commonwealth Bank is at a premium.

Rising rate hike risk

A stronger-than-expected rise in annual inflation has raised the risk of further rate hikes, with Friday's annual minimum wage decision also key to whether - and when - the RBA lifts the cash rate from 3.85%.

Inflation has risen to 6.8% in the year to April, the Australian Bureau of Statistics' monthly consumer price indicator released on Wednesday shows.

ANZ senior economist Adelaide Timbrell says the acceleration in inflation is likely to be a concerning result for the RBA.

"The risk around our forecast of a 4.1% cash rate in August has been tilted toward earlier and/or more action from the RBA," Timbrell says.

RBA governor Philip Lowe says the risks on inflation are slanted to the upside.

"Given what we're seeing internationally, I think the risks on inflation are more to the upside and we need to be attentive to this," Lowe told the Senate estimates hearing.

The RBA estimates about 15% of homeowners on variable rates will likely have a negative income surplus or negative cash flow by the end of the year.

That assumes they do not make adjustments like cutting back on discretionary spending or working more hours, RBA assistant governor Brad Jones says.

"Experience would tell us that they will make some adjustments; principally they will pull back on consumption and that's why our forecasts embed a projection of quite subdued consumption growth in the period ahead," Jones says.

The rebound in housing prices accelerated in May, with CoreLogic data showing a 1.2% increase and PropTrack figures, also released on Thursday, putting the rise at 0.33%.

CoreLogic research director Tim Lawless notes the outlook for housing remains uncertain given the possibility of further rate hikes, potential for increased mortgage stress and low consumer sentiment.

"It would be naive to think mortgage arrears won't rise through the second half of the year, however a material lift in motivated sellers seems unlikely," Lawless says.