Mortgage costs and the application process

This sub-section presents an overview of the application process and the associated mortgage costs for all mortgage applications generated by the bank (the raw dataset). First, mortgages are characterized by purpose – owner-occupier, investment, refinance – and product – fixed-rate or variable-rate. Then, mortgage costs and terms are described across contract stages, focusing on average loan size, term, repayments, interest rates and serviceability ratios.

3

During October 2003 most monetary variables such as loan payments, monthly expenses, salary and income have zero values.

Chapter 3. Data Description 43

Prospective borrowers who consider taking a mortgage usually have a meeting with a loan officer to learn about mortgage products and obtain pre-approval based on their assessed financial position. Once pre-approval is provided, a particular mortgage product is selected and a formal mortgage application is completed and submitted to the bank. The bank then assesses the application and makes a decision on whether to offer a mortgage or not to a particular borrower. Conditional on a successful application, the bank offers a formal mortgage contract to the borrower and provides more accurate associated mortgage costs and terms. Finally, the applicant can sign the mortgage contract or cancel it. In the dataset for this study 83 percent of loan applications are approved by the bank, only 0.06 percent are declined, and 17 percent are canceled by the applicant.

Although the vast majority of mortgage contracts seem to be settled on application day, on average it takes 2.5 days for the lender to inform the borrower whether the application has been accepted or rejected (some extreme cases take between 50 and 800 days). The dataset distinguishes different mortgage purposes and products. Over half of mort- gage applications are owner-occupier home loans (51 percent), 21 percent are residential investment property loans (RIPLs), while 25 percent are supplementary loans; see Table

3.1and Figure 3.1.4 These proportions are consistent with national levels for dwellings with secured finance, as reported by the Australian Bureau of Statistics (ABS). Dur- ing the sample period, 47 percent of all dwellings with secured finance were for owner- occupiers, 35 percent were for housing investment, and 18 percent were owner-occupation refinancing of established dwellings, as shown in Figure 3.2.5 Investors and homeown- ers are expected to behave differently due to the nature of housing as an investment or consumption instrument, and also because they face different incentives under the Australian tax system; see Sections3.4 and3.5.

The data allow the classification of mortgage applications into: variable-rate loans (63 percent), fixed-rate loans (15 percent), discounted variable-rate loans (16 percent), and 4_{Supplementary loans are home equity release loans with a fixed repayment term. Some 2.5 percent}

of mortgages are used to buy land and 0.6 percent are improvement loans (for house extensions for example). The spikes for the RIPLs in Figure 3.1may be related to the end of the financial year in Australia.

5

See ABS, Housing Finance 5609.0, Australia, Table 11, ‘Housing Finance Commitments (Owner- Occupation and Investment Housing), By Purpose: Australia, ($’000)’.

Chapter 3. Data Description 44

Figure 3.1: Proportion of Mortgages by Purpose, Number of Mortgage Applications.

Figure 3.2: Proportion of Mortgages by Purpose, Value of Dwellings under Finance Commitment.

Chapter 3. Data Description 45

Table 3.1: Mortgage Products

O/O Home Loans RIPLs Supplementary Total Variable Rate Mortgages (VRMs) 56.3% 55.2% 90.0% 62.8% Fixed Rate Mortgages (FRMs) 15.6% 25.2% 7.9% 15.1% ‘Honeymoon’ Mortgages (HMs) 23.3% 19.6% – 16.1% Home Equity Loans (HEs) 4.8% – – 2.8% Other Loans – – 2.2% 3.1%

(interest in advance or home improvement)

Total 51.4% 20.7% 25.4%

‘O/O’: Owner-occupied. ‘RIPLs’: Residential Investment Property Loans. Jan2003-May2009.

home equity loans (3 percent);6 see Table 3.1. Figure 3.3shows the evolution of these proportions over the sample period. The proportion of fixed-rate mortgages in the dataset is consistent with that reported by the ABS;7 see Figure3.4.

Figure 3.3: Proportion of Mortgages by Type, Number of Mortgage Applications.

The vast majority of loans are classified as residential mortgage securities.8 While a third of applications have had no changes to the original application, half have suffered between 1 and 3 modifications. Additionally, 4 percent of borrowers are reported as

6

Home equity loans differ to supplementary loans in that supplementary loans are loans secured by the equity of an existing property with frequent repayments and a term for the life of the loan. A home equity loan is a line of credit secured by a mortgage on an existing property with a amount limit but with no scheduled repayments or loan term.

7

See ABS, Housing Finance 5609.0, Australia, Table 9a ‘Housing Finance Commitments (Owner Occupation), By Type of Buyer and Loan: Australia, original’.

8

Chapter 3. Data Description 46

Figure 3.4: Proportion of Fixed-Rate Mortgages.

holding multiple home loans and 9 percent reported having a prior mortgage with a median value of AUD $183,615.9

The dataset distinguishes three stages in a mortgage contract: (1) application stage, (2) offer stage, and (3) final stage. In each stage the data report: date, loan amount, number of applicants, term (life) of the loan, interest rate, repayment amount and repayment frequency (weekly, fortnightly or monthly), total contribution (amount for deposit, cash contribution and other contribution), credit score, the purchase price and the decision on the contract.

Table3.2 shows brief summary statistics of mortgage characteristics by contract stage. At the initial application stage borrowers apply for the mortgage product that most closely satisfies their needs and preferences. The average applicant requests a loan size of AUD $215,682 during the sample period. The average loan size is smaller during the offer stage. However, at the final stage, the average loan contracted is AUD $216,069,10 with a median of AUD $177,084. At this stage, a third of all mortgages are contracted by a single applicant, while two thirds of borrowers submit a joint application. Over half of

9

All monetary values in this chapter are real values in 2011-12 Australian dollars (AUD $) to simplify comparison with national level data. However, the rest of the chapters show real values in Q1 2006 Australian dollars, selected as a midpoint in the time of the sample period.

10

There is evidence of some loan size and interest rate negotiation between the stages of the mortgage contracting process.

Chapter 3. Data Description 47

mortgages are a 30-year contract, however the mean mortgage term is 25 years.11 Almost half of borrowers make monthly repayments, a third make fortnightly repayments and 20 percent make weekly repayments.12 Calculated average monthly repayments at the initial stage are around AUD $1,585. Average monthly mortgage repayments are around AUD $1,570 at the final stage. Bank fees are determined at the offer stage; they are on average AUD $809 – representing a once-off bank application fee.

Table 3.2: Mortgage Characteristics by Contract Stage Application Offer Final Average loan size $215,682 $205,428 $216,069 Average loan term 26 25 25 Average monthly repayments $1,585 $1,514 $1,570 Average bank fees – $807 $809

Average interest rates follow the target cash rate reported by the RBA as shown in Figure

3.5. Initial interest rates at application time are slightly lower than the ones offered and agreed on at the final stage of the mortgage contract. This discrepancy could be due to a series of reasons: the final loan size may be larger or the term of the mortgage contract may be shorter, or the final interest rates may include forward looking information relative to initial interest rates which may follow previous market assessments. However, a more likely reason could be that the final interest rate incorporates some premium based on the credit assessment of the borrower. Owner-occupier mortgages and RIPL interest rates are lower than those offered on supplementary mortgages or home loan improvement mortgages. Interestingly, during most of the period the average interest rate for a fixed-rate mortgage is lower than that of a variable-rate mortgage. This is not the case for most of the mortgage choice literature in the U.S.; Badarinza et al. [18] show that the interest rate spread between fixed-rate and adjustable-rate mortgages is always positive for the U.S. and Italy, but has been negative for some other countries, especially for Australia. Discounted variable-rate mortgages offer the lowest rates, while home equity loans show volatile average interest rates.

The dataset also reveal mortgage ratios such as payment-to-income ratio (PTIR), debt service-to-income ratio (DSR), and loan-to-value ratio (LTV). Monthly payments rep- resent on average 21 percent of monthly net income (PTIR) for the whole sample. The

11

Only 15 percent of mortgages in the sample have a term of 10 years or less.

12

These results are surprising as it is common knowledge that more frequent repayments will decrease the outstanding principal faster with compounding interest.

Chapter 3. Data Description 48

Figure 3.5: Average Interest Rates.

DSR – which is calculated as annual mortgage payments, property taxes and other debt payments as a proportion of gross household income – is on average 45 percent.13 The LTV is an important factor in the mortgage contract, with an average of 61 percent in the sample.14 This value is consistent with national levels for the period; APRA reports an average LTV of 67 percent for Australia.15 Figure 3.6 reveals the distributions of these financial ratios, while Figure3.7shows their mean trend over the sample period.16 The LTV is relatively constant, however the DSR has an increasing trend until the global financial crisis.

The data report mortgage terms and conditions, but also reveals applicant information. The next subsection describes the raw data collection on borrower characteristics.