Reducing risks of borrowing
As the banking regulator APRA's recent attempts to slow the growth of investment property borrowing show, historically low interest rates and the easy availability of credit have increased the risks for both borrowers and lenders.
APRA wants to ensure that collectively and individually our financial institutions don't experience financial stress which could lead to a crisis and insolvencies similar to those in the GFC.
No equivalent institution exists to caution individual borrowers about the risks they are taking by borrowing especially large amounts for home ownership or investment purposes. Indeed if anything, the central bank and government are encouraging people to borrow by their low interest rate policy and ruling out changes to the negative gearing tax subsidisation of investment losses.
This is why borrowers need to be aware of the risks they are taking on and develop strategies to reduce their possible impact. The first and most important point to understand is that just because an institution is prepared to lend money doesn't mean that they've evaluated the merits of the item being purchased.
Lenders are naturally more interested in the borrower's creditworthiness and ability to service the loan. In this process, they rarely delve into or consider the risks of future unemployment and relationship breakdown, nor do they consider the risks of a large unexpected rise in interest rates.
Unlike in the United States, where fixed interest rate loans for up to 30 years are the norm, the Australian system places the risk of interest rate increases fully and squarely on the borrower. This means that while borrowers can be certain that interest rates will remain low while the world economy struggles, the situation could change quickly in the future.
Consequently, many existing borrowers have been taking the opportunity to reduce their outstanding mortgages using the additional cashflow provided by falling variable interest rate loans. The clear message for new borrowers is that a faster repayment than required by the lender will also reduce their future risks.
In the case of investment borrowings, tax arrangements encourage a different approach, particularly when the borrower is subject to a high marginal tax rate. In this situation, paying off an investment loan will increase tax liabilities, negating part of the benefit.
Many investors therefore opt for interest-only loans and use all their savings to reduce any personal debts such as any mortgage remaining on the family home. Indeed, the smartest investment strategy to reduce borrowing risks is to own the family home outright and borrow on a tax-deductible basis for investments.
Among other benefits, this strategy ensures the tax deduction for interest payments on investment loans provides an excellent buffer protecting against the costs of future interest rate rises.