Should new homeowners be worried about Low Equity Margins?

ANALYSIS: The latest OneRoof House Price Report figures show the nationwide average property value fell by 2.9% in the three months to the end of June. Not all regions have dipped, with Canterbury's average property value up 2.1% over the quarter and Taranaki's up 1.4%. And some regions have fallen further than others, with the average property value in Greater Wellington down 8.3% over the same period.

Few homeowners will be happy about the sudden shift in the direction of the housing market, but just as increases in the value of your home don't necessarily add dollars to your bank account, decreases won't necessarily drain your bank account either. Falling values are only an issue for those homeowners looking to sell soon. Remember, it's only a loss or gain on paper until you sell.

However, one concern recent buyers may have is whether or not banks will charge additional fees if their mortgage goes from low risk to high risk.

Lenders - and the Reserve Bank of New Zealand - generally view a mortgage as "low risk" if the total mortgage on a property is less than 80% of the property's value (less than 80% Loan to Value Ratio). Besides only having limited funds to lend to higher-risk mortgages, lenders also add additional costs to compensate them for taking this risk. They do this in two ways. Some banks charge a one-off fee (commonly referred to as a Low Equity Fee or LEF), while others charge a slightly higher interest rate (commonly referred to as adding a Low Equity Margin or LEM). For new homeowners, there are circumstances where a LEF is better -such as if the house value is above 80% the threshold for more than a year - and times when a LEM is a better option. Recently, buyers have just had to settle for whichever bank will lend them more than 80% regardless of how they charge for the pleasure.

Regardless, most low deposit borrowers in the past few years have had to pay either this one-off fee or suffer the additional interest rate until their lending has dropped below the magical 80% LVR threshold.

So now, with house values declining, will homeowners who were just below the 80% threshold now be forced to pay additional costs? For example, would someone who borrowed $800,000 to buy a $1m property in Wellington last year be at risk if their house is now worth $917,000 and their mortgage is at 87% LVR? An additional 0.75% Low Equity Margin on top of what could be a 5.35% interest rate would be quite a knock to their finances especially if they were coming off a 2.19% rate.

Mortgage Lab founder Rupert Gough: "Banks are unlikely to want to put financial pressure on their customers." Photo / Fiona Goodall

To guess how the banks will respond, we can look at how they have acted in the past. In recent years, when a customer's LVR has moved from 90% to 80%, the banks haven't always automatically removed the Low Equity Margin; they have usually required someone to review the loan manually. Cynics might say this is because leaving the additional interest charges there earns the bank extra income. In other words, the banks occasionally charge an additional margin on interest rates even though the property is low-risk.

A less cynical view would be that nailing down a value on a property is quite hard, particularly in a volatile market, and incorporating an automatic interest margin could get messy. For example, imagine trying to pay a mortgage when the LEM was turned off one month, only to come back the next month, only to turn it off again the following month. Values can move around significantly from month to month. An automated process could be worse than asking for the margin to be removed manually.

So if the LEM needs to be manually turned off upon request, it seems logical to need to be turned on again by request. In other words, if your mortgage was below 80% LVR and now, as a result of the value of your house falling, has gone above 80%, you're not automatically going to have to pay a Low Equity Margin (or worse, a Low Equity Fee which could be $5,000 or more)... unless you specifically ask for it.

Furthermore, the banks are unlikely to want to put financial pressure on their customers. Homeowners face interest rates that have increased by 3% per annum in a year. Adding a further 0.25% to 0.75% per annum could push people to refinance with a lender that only charges a one-off fee.

In short, the risk of low-equity margins and fees being charged to current homeowners seems unlikely. Homebuyers who bought in the past year can, at least, cross that off their list of things to worry about.

- Rupert Gough is the founder and CEO of Mortgage Lab and author of The Successful First Home Buyer.