Legacy LRBAs locked into ‘mortgage prison’ as banks apply rate pressure

The central bank has left the door open to further increases over the coming months, with some economists projecting a terminal cash rate of 4.1 per cent.

Established banks have been quick to pass on higher funding costs to borrowers, with limited resource borrowing arrangements (LBRAs) for SMSFs no exception.

In fact, according to Peter James, executive director of non-bank lender Mortgage Ezy, legacy SMSF loans have been hit with higher repayment burdens relative to the typical borrower.

He said SMSFs repaying legacy loans issued by established banks — which have since ceased lending to SMSFs — are paying as much as 10 per cent in interest.

“When you’ve got legacy loans, there is no incentive for the lender to keep a small pool of loans on the book because you require specialised staff to administer them and there really isn’t any economy of scale,” Mr James told SMSF Adviser.

“So, the temptation is, if you’re going to have to keep these loans, you might as well make a very strong return on them.

“So, as the RBA goes up 25 bps, these loans might go up 40 or 50 bps at a time.”

Banks have been criticised for their response to the RBA’s tightening cycle, particularly for the extent to which they’ve rewarded depositors with higher savings rates.

The criticism has intensified in recent weeks, with the big four banks – ANZ, Commonwealth Bank, NAB, and Westpac – reporting record profits in their most recent financial updates to shareholders.

The majors posted $16.7 billion in statutory profits over the first half of the 2023 calendar year (1H23), up 10 per cent on 1H22.

Return on equity (ROE) rose 190 bps to 12.6 per cent, while the net interest margin (NIM) increased by 17 bps to 1.88 per cent.

According to Mr James, the worst is yet to come for borrowers, with banks expected to increase their exposure to the higher-cost residential mortgage-backed securities (RMBS) market as cheaper sources of funding from customer deposits and central bank facilities dry up.

“Up until now, virtually no bank has tapped the RMBS market because they’ve had this source of very cheap money,” he said.

“We think in 2023, most banks will have to replenish, to some extent, with the bond market. But while they’ll pay a higher rate for that money, it will constitute such a small percentage of their portfolio – it won’t be material.”

As such, Mr James has urged SMSF trustees to review their lending arrangements and consider refinancing with non-bank players before it’s too late.

“My advice to them is to make sure they refinance sooner rather than later because it’s only going to get worse,” he added.

He acknowledged many SMSFs may be locked into their legacy loans, given they may be unable to meet serviceability requirements to refinance.

At present, the Australian Prudential Regulation Authority (APRA) requires lenders to apply a 3 per cent serviceability buffer on top of the advertised rate for a new loan.

“The issue by waiting too long is that because contributions are limited in their self-managed super fund by law, you may find that you don’t have the serviceability to go to another lender, even if it’s going to save the fund a massive amount of money,” he observed.

“You may be what is called a ‘mortgage prisoner’ because the actual serviceability includes a buffer.

“So even if someone was to refinance from a 9 per cent loan to [Mortgage Ezy’s] 6.19 per cent loan, it still has to be serviced around that 9 per cent mark to cover increases to interest rates.”

Mr James said he does not expect rate relief any time soon, claiming the RBA is unlikely to cut rates before the close of 2023.

“I do not think interest rates are going to go down this year, that’s my prediction.”