Originally published by Cuffelinks
Industry regulator, ASIC, recently completed the largest data collection project in its history to produce Report 516 – Review of Mortgage Broker Remuneration. A few years ago, ASIC’s deep dive into the financial planning industry resulted in the introduction in 2013 of the Future of Financial Advice (FoFA) reforms. With mortgage brokers now dominating the nation’s home loan industry, ASIC scrutiny was inevitable.
Encouragingly, ASIC largely gave the mortgage broking industry a clean bill of health. However, it had this to say about the increasing prevalence of interest-only loans:
“Compared to consumers going directly to lenders, we found that consumers going through broker channels obtained significantly more interest-only loans: for all eight lenders reviewed, brokers arranged at least 50% more interest-only loans… All other things being equal, loans with higher amounts, and/or interest-only terms, will cost the consumer more in interest and may take longer to pay down.”
The premise is that an interest-only loan is not in the borrower’s interest. This is not correct, as interest-only may be the best option and often substantially so. This is an example of one arm of government (ASIC) not talking to another (ATO) for consistent policy. Another regulator, APRA, is on the same page as ASIC when it recently introduced a requirement that interest-only loans comprise no more than 30% of new loans.
The reason more broker-originated loans end up as interest-only loans is simple — brokers are doing a good job. The fact that bank branch-originated loans have fewer interest-only loans shows a lack of sophistication of some bank branch staff who sell mortgages.
In addition to minor and probably positive tweaking of brokers’ remuneration structure, the report stated in its executive summary that:
“Brokers play a very important role in the home loan market. They are responsible for arranging around half of all home loans in Australia. Consumers are increasingly turning to brokers to get help in obtaining a home loan — in 2012 brokers arranged 47.7% of home loans for the lenders in our review. In 2015, this increased to 54.3%.”
“From a competition perspective, brokers have the potential to: (a) play a valuable role in providing a distribution channel for lenders — especially smaller lenders — without their own distribution network (e.g. branches); (b) exert downward pressure on home loan pricing, by forcing lenders to compete more strongly with each other for business.”
That’s all good, but ASIC is wrong about interest-only loans. Australian taxation rules mean that for many owner-occupied borrowers the smartest structure is an interest-only loan. This appears counter-intuitive but it is a key point that needs spelling out. Here’s how it works.
Imagine Jack and Jill want to buy their first property, which will be owner-occupied. If they go to the local bank they will probably walk out with a principal and interest loan. A good broker, on the other hand, will make a careful assessment. If Jack and Jill have a poor record in managing their money (that is, high credit card balances, car loans, unimpressive savings) then, of course, a good broker will also suggest principal and interest repayments so they are at least chipping away at their debt.
If, however, the broker can see Jack and Jill have no personal debt and solid savings plus a promising employment future, they will ask, “Do you think this first home may one day become an investment property?” Good borrowers will often respond, “Yes, it is our hope we will buy a bigger home in the future and retain our first property as a long-term investment.”
So, the good broker will spell out how an offset account works and explain that rather than officially reducing the principal on their first home they are significantly better off paying interest-only repayments. They are effectively paying off the debt by accumulating cash in the offset account.
They will achieve two positives. In addition to reducing debt, they are accumulating a larger cash deposit for their future home in their offset account, and will, therefore, have a lower non-deductible debt. They will accrue greater tax benefits from their first property when it becomes an investment property with a deductible debt because the principal has not been eroded. They will only consider reducing the principal on their first property’s debt when their long-term home is debt-free. All debt is bad, but home-loan debt is worse than investment debt due to the latter’s tax deductibility.
I have met countless good borrowers who were approved for their first property loan via a bank branch and, thinking they were doing the right thing, paid down their principal significantly. It was only when they bought their long-term home that their accountant correctly advised that their first purchase is now not a good investment property. The borrower will protest, “No, it’s a great property” but the accountant will explain, “It has too much equity and you have too little cash so your new non-deductible home loan is too high.”
These borrowers are then forced to sell their first home and incur selling costs as well experiencing frustration that no-one explained the long-term implications of principal and interest repayments. This bad loan structure costs good borrowers much time and tears and needlessly diminishes their wealth.
If the government wants to reduce the number of interest-only loans, then fine, that’s their call. But they need first to restructure the tax system and not punish smart mortgage brokers helping quality borrowers. Alternatively, they could just leave things as they are. ASIC and APRA – meet the ATO. You should talk.
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