Compliance update - Assessing rental income for loan servicing
Are lenders double dipping?
The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry has already caused lenders to change the way they assess credit applications. We’re seeing changes to Household Living Expense assessments verses HEM and HPI benchmarks and the reintroduction of Debt Service Ratios (DSR’s).
Importantly, there has also been a move by lenders to change long held conventions relating to the discounting of rental income prior to including it in servicing calculations.
What has changed?
Prior to the Royal Commission hearings and the intense focus on Household Living Expenses, lenders’ credit policies required rental income to be discounted by up to 20% to account for rental costs. As a common held understanding by brokers, this was thought to be sufficient as the sole form of ‘netting out’ gross rental income. There was little difference between lender credit policies and it was acceptable to simply shade the gross rental income and add the net figure to other sources of servicing income to determine the Net Servicing Ratio (NSR) of a lending application.
Recent moves by lenders have seen credit policies amended so that rental income shading reflects a buffer for perceived vacancy rates (past, present or future), while the assessed or actual rental expenses are also required to be added to the customer declared Household Living Expenses.
Is this double dipping?
Some brokers have protested that this is a ‘double dip’. There is a growing concern expressed by some in the broker community that these changes could result in more loan applications reliant on rental income being declined. Claims by brokers and property investors that current rental vacancy rates don’t support such a tightening of policy, were denied by lenders who say that credit policies have always assumed rental expenses were required to be allowed for in the assessment of Household Living Expenses, and that the shading of rental income was always required to counter prospective vacancies.
Whether we agree or not, this is not seen as a double dip by lenders. We are in a regulatory and fiscal environment that is under increased scrutiny by the federal government and regulators, and this is resulting in a tightening of lender policies across the board.
How is net rental income documented?
There are two generally accepted methods of documenting how net rental has been derived:
- Include all rental expenses in the Preliminary Assessment Household Living Expenses (HLE) Declaration Section (i.e. council rates / water & sewerage / repairs & maintenance costs / insurances etc). This increases the total of household living expenses used when determining whether HLE or HEM is applied in the lender’s servicing calculator.
- Discount the total gross rental income by the lender’s required percentage (i.e. 20%) then deduct all applicable rental related expenses to arrive at a net rental income. This effectively ‘nets out’ the rental income that is added to all other servicing income and applied to the lender’s servicing calculator.
Lender policies differ on these calculation methods and brokers should take care to familiarise themselves with each lenders’ policy. Option (2) is tailored more towards commercial rental scenarios than residential, as there are generally no HLE / HEM benchmarking requirements in commercial lending. Option (1) provides a better reflection of the effect rental expenses have on household living expenses and with lenders being more critical when assessing HLE against HEM, it is often best to use option (1) when applying rental expenses to the servicing equation.
In using either method, brokers should evidence how they have arrived at the expenses applied to net out the rental income, just as is required to evidence and confirm all other household living expenses.
How will this affect loan approvals?
The requirement to apply a discount to gross rental income, as well as deducting actual expenses, will obviously affect approval results compared to previous lender policy requirements. There will be scenarios where the ‘double hit’ effect of the rental discount and expenses push servicing outcomes below the minimum NSR’s.
It may help to look for ‘one off’ expenses that can be highlighted in your submission notes as non-repeating and include evidence about vacancy rates for the suburb in which the rental property is located. Where these facts support an alternate view to the lender serviceability assessment, you can argue for the omission of one off expenses, or for a lower rental income discount to be applied based on historical and prospective vacancy rates.
Connective Property Tools by CoreLogic provide a simple, useful tool for researching rental vacancy rates. If you’re not yet a subscriber, find out more here. There are also many other websites brokers can use to assist with research. Some popular sites are:
What else do you need to do?
The overall message being delivered by lenders and regulators is that they are expecting greater rigour to be applied when assessing all consumer loan applications. This places pressure on you to ensure all income and living expenses assessments are accurate.
The changes to how brokers must assess rental income in an environment where Australia is at the top of the property cycle and the bottom of the interest rate cycle, are a result of the overall concern regulators have about the financial security of Australian households.
If you have any questions or require support from your local Compliance Support Manager, please don’t hesitate to get in touch. Simply click the help icon in Mercury or email us at email@example.com