5 tips to avoid mortgage prison

The threat of ‘mortgage prison’ has been bearing down on Aussies in the wake of continued interest rate hikes and tightening economic conditions. However, many borrowers still have a chance to avoid this trap.

So, you might be wondering what mortgage prison even is?

In short, mortgage prison occurs when a home loan borrower can no longer refinance their debt because they lack sufficient equity or don’t meet a new lender’s serviceability requirements.

With more than 100,000 Australians potentially already facing mortgage stress, many borrowers are starting to fall into the mortgage prison trap. The question is, how do we move forward in a much tougher economic environment.

Mortgage prison explained

When a borrower can no longer refinance their home loan it can certainly feel like a prison! This can be especially bad for people who took out their loan below a 20% loan-to-value ratio (LVR), meaning the size of their actual loan was quite large to begin with because they put down a smaller deposit. Then, as higher variable interest rates have stacked up on their repayments – amid falling property prices – some borrowers find themselves in a fix, desperate to refinance but with little ability to do so. 

In the most severe forms of mortgage prison, borrowers can struggle to cut back on everyday expenses as they may be living paycheck-to-paycheck or even paying for more than they can afford. 

Why are more people becoming mortgage prisoners?

Mortgage prison doesn’t necessarily happen to people who are “bad borrowers” or low income earners, although these things can be significant factors. 

Overall, interest rate hikes, falling property values (resulting in lower equity) and the cost of living crisis have made economic conditions difficult for many borrowers.

How do we escape mortgage prison?

With significant financial headwinds, it can seem like a monumental task to try and avoid falling into mortgage prison. However, there are some strategies that can be utilised.

Mortgage broker at Two Red Shoes, Brett Sutton offers a few of the following tips to avoid falling into mortgage prisoners.

1. Manage your debt to income ratio

Any debt you’ve got in addition to your home loan could be seriously affecting your chances of escaping mortgage prison. Checking for—and paying off—any outstanding car loans or credit card debts can drastically reduce monthly repayments.

As Sutton points out, the home loan itself isn’t always the problem. Instead, a lot of people are caught out by these subsequent smaller loans that, overall, still add up to a repayment that is significantly harder on your budget.

2. Reduce discretionary spending for 3-6 months

With economic pressures mounting, banks are increasingly weary of borrower spending habits and have increased the numbers for their living expenses calculations. This can have a significant effect on your buying power.

To give yourself the best chance of being able to refinance, make sure that you pull back your everyday spending to the essentials as much as possible.

3. Check your LVR

Negative property values can lead some borrowers on a higher Loan-To-Value-Ratio or LVR – 95% for example – to be at much greater risk of their mortgage becoming unaffordable if further market contractions occur. 

Banks can also increase interest rates for all LVR tiers due to market contractions. This would mean that even relatively lower LVRs—such as those at 80%—are still at risk of having to pay higher interest rates

Overally, making sure you have enough wriggle room in your current loan in case interest rates or property values fall. If not, refinancing may be a good option to reduce your risk of mortgage imprisonment.  

4. Look up your bank’s age policy

Most banks have their own individual policy in regards to the expected retirement age of the borrower. Owner-occupiers with a loan term that extends into the bank's retirement age limit can cause problems.

Sutton suggests keeping a viable exit strategy or possibly even downsizing can help borrowers to manage any potential pitfalls. 

5. Consider refinancing early

Refinancing to a more competitive loan before your current one gets out of hand can help in avoiding the mortgage prison trap. Besides, refinancing now could be an advantageous move if you’re worried about continued interest rate hikes.  

Part of what makes refinancing difficult in a mortgage trap is that banks will usually stress test their loans. This will often involve adding a 3% buffer to their calculation on top of the interest rate that you would be currently paying. With higher interest rates, this has put refinancing out of reach for many.

Finding the right home loan is the first step. Here at Mozo we have comparisons of all the best home loan providers to help you find the loan that suits your needs.