Coming up: A hard lesson in refinancing risk?

I was interested to see this week that ING have announced  the introduction of Loan to Value Ratio (LVR) based pricing for some of their home loan products. Borrowers who have LVRs below 80% will get a cheaper rate than those who don't. Westpac also took some baby steps down this path a couple of years back by limiting LVRs for new customers to 87%.

Early days yet, but could this be the start of a trend towards full-blown LVR based pricing? This would certainly be a more appropriate way for the banks to price the risk on their balance sheets and it would be good news for borrowers with low LVRs. It would also be a shift back to the more traditional banking model, where banks focused on those with strong savings records (reflected by a large deposit).

But it would be bad news for those borrowers who took advantage of the trend to higher LVRs during the 'good old days' of the global asset boom. Not only would they end up paying higher interest rates than others, but they could end up out of a reasonably priced home loan altogether. As institutions like ING chase 'low LVR' customers, the Big 4 will be forced to compete on pricing (the last thing they want is the average LVR of their home loan book to start rising). This, in turn, will force them to increase pricing to customers not being chased by the INGs of this world. These customers may well end up being the future version of the credit card holder where they get charged 'whatever it takes' (to make profits).

Where it gets really ugly is if the Big 4 decide they want to leave the 'high LVR' business altogether. Unfortunately too many Australian borrowers are sitting on the quirky Australian version of 'variable' rate (aka 'you pay what we ask'). Those who have fixed will typically only be fixed for a few years (certainly not the term of their home loan). They will also end up on 'self determined' variable rates at some point.

The easiest way for the Big 4 to exit the 'high LVR' business (or at least make it worth the risk) is to keep on increasing their self-determined variable rate, while increasing discounts for low LVR customers. There will be some political heat, sure. But a lot less than there is now, since high LVR customers carry far fewer votes than the total pool of bank customers (and the rest will be happy chappies). Mind you, I haven't analyzed the relationship between LVRs and marginal seats, so I might be underestimating the political heat.

Unfortunately, if things did play out this way, high LVR customers would have nowhere to turn to refinance at reasonable rates. Like car dealers and RAMS Home Loans during the GFC, they would learn the realities of refinancing risk the hard way. Their choices would be ugly - pay the higher rates, go broke or hope for a Government bailout.

Let's hope we don't ever get to this extreme. It would be ugly from both a social and economic perspective. But it seems inevitable it will happen at least to a degree - tiered pricing based on LVRs with high LVR customers paying higher margins than they do today.

There is also a lesson here for anyone relying on specialty finance (SMSF property loans spring to mind). If your term and rate (or at least its calculation) are not locked in, for the full period you need the cash, then you are taking refinancing risk. And if it does ever raise its head and bite you, it will do so at the worst possible time. If you need to sell to repay the loan you will likely be selling into a buyers market, increasing your losses.

This is the biggest problem with refinancing risk - it tends to get you at the same time it is getting everybody else.