Australian loan-to-income ratios exceed UK

In the interests of financial stability, the Bank of England has announced mortgage lending caps based on loan-to-income ratios despite household loan-to-income (LTI) ratios being lower than in Australia.

After its June meetings, the UK central bank’s financial policy committee (FPC) recommended the bank regulators ensure mortgage lenders don’t extend more than 15 per cent of the total number of new home loans at LTI ratios at or greater than 4.5.

It noted there had been a sustained increase in the share of new mortgages with high LTI multiples to the point they now accounted for around 10 per cent of new lending and that house prices were growing well in excess of earnings.

The potential indirect risks to financial stability from household indebtedness were discussed given households with hefty debt burdens were most likely to fall into arrears, triggering the risk of default which could result in a loss for banks.

Rule of thumb

Martin North, principal of boutique consultant Digital Finance Analytics (DFA), views LTI ratios as a useful indicator because they remove the impact of changes in house prices. 

When North worked in a UK bank as a lender the rule of thumb was to take three times the first income and add one times the second income as a measure of the loan available to the household.

“Although rough, it was not too bad,” he said. “Since then, lending rules have changed and criteria stretched.”

“This ability to lend more has in turn led to higher house price inflation, thanks to supply/demand dynamics,” said North.

The FPC noted the persistent gap between the rate of house building and the growth in demand, based on estimates of desired household formation rates, which partly explains why house prices are rising faster than earnings.

Also like Australia, residential mortgages are the largest single asset class on the major UK banks’ balance sheets and the largest share of household debt.

UK example

Given the similarities between the UK and Australia, DFA examined how Australian household LTI ratios compare.

It found that based on the gross annual income of Australian households, the distribution of LTI ratio ranged between 2.25 and eight, with two big clusters, one around 4.25 and another at 6.25.

That compares with the zero to six per cent range for UK LTI ratios, with most siting around 3.25.

Given a central scenario that the trajectory of UK house prices would continue in the near term before falling back in line with nominal incomes, the FPC expects the share of mortgage lending at LTI multiples higher than 4.5 to increase from around 10 per cent to 15 per cent.

On that basis, a second cluster would arrive at an LTI ratio of five times.

Australia more stretched  

The FPC noted the risk that housing activity could grow more rapidly with house price inflation outpacing earnings even more which would cause the proportion of high LTI lending to “increase sharply”, hence the caps announced in the last week of June.

On DFA’s analysis, LTIs in Australia are more stretched than in the UK. Australia’s regulators don’t regularly report LTI data which North regards as a significant gap.

DFA looked at the LTIs in Sydney in particular and found a “significant” concentration of high LTI loans in the western suburbs. There was also a correlation between higher LTI loans and mortgage stress.

It noted that younger buyers, particularly first home buyers, are associated with the cluster of LTI ratios around 6.25. These highly leveraged borrowers are coping for now with today’s very low interest rates but that won’t be the case when interest rates return to normal settings.

“This suggests that the LTI situation in Australia is more adverse than the UK scene,” said North.

“While we note the UK regulator is acting, there is no macro-prudential intervention in Australia. There should be.”

loan-to-income, FPC, LTI, central bank, UK, Europe, mortgage lenders, Digital Finance Analytics, DFA
Marion Williams,
Article Posted:
July 07, 2014

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