Monitoring of debt to tighten as rates may rise

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Monitoring of debt to tighten as rates may rise

From February, banks in the Seoul metropolitan area will scrutinize borrowers’ ability to repay their debt under stricter rules as part of the government’s household debt management plan.

The Financial Services Commission (FSC), the country’s top financial regulator, announced on Monday a detailed policy plan for enhancing the current credit review system to better monitor the country’s rising household debt.

The announcement comes amid growing criticism that the government encouraged the people to buy residences with loans to revive the flagging housing market and boost domestic consumption - at the risk of their financial well-being. Korea’s aggregate household loans stood at 1,166 trillion won ($979 billion) as of September and are expected to surpass 1,200 trillion won by the end of the year.

The debt burden on households is expected to get more painful as the U.S. Federal Reserve is expected to raise its benchmark interest rate this week by 0.25 percentage points for the first time in nearly a decade. The U.S. rate hike would likely prompt central banks in other countries, including the Bank of Korea, to adjust their interest rates upward, which will raise the cost of servicing non-fixed interest rate loans.

The main idea of the plan is to examine borrowers’ financial abilities more closely and force banks to be more careful about the loans they extend. Banks will also recommend borrowers repay interest and principal simultaneously from the beginning. Some loans in Korea only ask for interest payments for up to 10 years.

All new mortgages will be issued in the form of amortized loans, which require principal payments from the start. Grace periods of a maximum of one year on principal payments will be afforded to some borrowers, but only to those with financial difficulties.

Current mortgage holders who have been paying interest only will be recommended by their banks to switch to amortized loans.

Under the debt-to-income (DTI) and loan-to-value (LTV) rules, people who plan to borrow more than 60 percent of their annual incomes or of their collateral values, which are considered risky, will be subject to the tightened screening.

The current DTI ratio stands at 60 percent for borrowers in the Seoul metropolitan areas. The LTV rate is 70 percent for all regions.

When borrowers are reviewed by their banks, they must submit withholding tax invoices and income certificates.

Banks will also apply an interest rate “stress rate” on potential borrowers to see if they can afford loans when interest rates rise in the future. It will set optimal DTI ratios.

The stress rate is set by the Korea Federation of Banks based on the average rate of new mortgages every five years.

For example, if a person with an annual income of 30 million won plans to purchase a 300 million won apartment, the DTI ratio for him is 79.2 percent. He can borrow 210 million won over 10 years at a floating rate that starts from 2.5 percent.

When interest rates rise, that borrower’s DTI will rise with it, and the bank will advise him to borrow less.

“The purpose of applying the stress rate is not to raise mortgage rates, but to limit the amount of issuable mortgages,” said Yun Sung-eun, general manager for the credit services department at the Korea Federation of Banks.

The FSC forecasts that about 20 percent of the average of new mortgages (126 trillion won every year) will be converted to amortized loans. And 2.8 percent of new mortgage holders would be monitored with the stress rate.

Banks will introduce a debt service ratio (DSR), too, which is considered an expansion of the current DTI regulation. For the DTI ratio, banks calculate the interest and principal repayments on mortgages and interest payments on other loans and compare them to a borrower’s annual income.

The DSR also calculates principal repayments on other loans. Borrowers with high DSRs will be steadily monitored by banks.

“Borrowers with a high DSR will be advised by their banks to help reduce their debt burdens,” Yun said. “It is not a regulation that limits the amount of lendable loans.”

The plan only provides guidelines for banks. Banks will have to set their own internal regulations to manage household debt in terms of quantity and quality.

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