A perspective on the national economy, inflationary pressures, interest rates, house prices, household budgets and cost of living......
UNSW, media release, 7 November 2022:
What
happens to the economy if you can't pay your home loan?
Australia
is seeing mortgage stress and other cost-of-living pressures rise,
but we can avoid the financial impact being felt in the UK and US,
says a UNSW Business School real estate expert.
For
economists – and indeed, anyone else with an interest on how much
they spend at the supermarket – cost-of-living and housing prices
have been hot topics in 2022. The Reserve Bank of Australia (RBA) has
been trying to combat rising inflation with interest rate raises
(read
how that works here).
The
latest rise was announced by the RBA last week on November 1, with
the official cash rate rising to 2.85 per cent.
This
process has contributed to a
fall in house prices in some areas,
as well as fears from mortgage holders that they won't be able to
make payments on the now larger amounts.
“Australians
have been fortunate to see sustained house price growth for a while
now,” says economist and expert in real estate markets, Dr Kristle
Romero Cortés Associate Professor in the School of Banking &
Finance, UNSW Business School. “But they need to know, house prices
can come down too.”
But
while data
from the Domain Group (shares of which are majority owned by Nine
Media) might have recently shown the sharpest quarterly decline in
house prices since 1994 across the country’s biggest capital
cities, Dr
Romero Cortés isn’t unduly concerned about house price falls.
“Commentary
on the housing market is quite sensationalised in the media.”
But
when it comes to not being able to pay the mortgage, and the impact
higher loan repayments might have on the economy? That’s a bit more
complicated to predict.
Why
Australia may not follow other countries into financial disaster
Australians
only have to look over to the United Kingdom to feel nervous when
witnessing the impact of high inflation and interest rates on the
economy and the day-to-day lives of financial situation of its
citizens.
Like
Australia, the UK’s central bank (the Bank of England) has
introduced a series of interest rate hikes that have had a limited
effect. Unlike Australia, the UK economy is still reeling from
Brexit, plus a post-pandemic recovery, high inflation and energy
costs, and levels of wage stagnation that have seen various sections
of the working population strike.
The
country has also just experienced the effects of a disastrous set of
economic policies and extensive tax cuts for the wealthy implemented
by Liz Truss as prime minister, which would have put money into in an
already inflated economy (where
the idea is to usually ‘cool’ things by encouraging people not to
spend).
This
spooked the financial markets to such a degree that investors quickly
sold off British assets, including government bonds. The value of the
pound plunged, forced the Bank of England to take an unprecedented
step and pledge 65 billion pounds worth of bonds to stop pension
funds from failing and stabilise the market … and caused Liz Truss
to resign after just 44 days.
For
the average Briton, this situation has led to a greater threat of
recession: something which could lead to loss of jobs, higher
unemployment, higher inequality, wage growth that is too low to match
price increases, and issues meeting costs, such as regular mortgage
payments that have already risen because of interest rate hikes.
But
does the UK situation foreshadow D-R-A-M-A for the Australia’s own
economy and housing market? Dr Romero Cortés says no – for several
reasons.
Australians
are fans of variable rate loans - unlike in the UK
As
well as not experiencing a Brexit-like crash or an energy price
crunch to the same degree, a big point of difference is that
Australians are more likely to have opted for the more flexible
variable rate mortgages, than in the UK, where homeowners are more
likely to have picked fixed rate mortgage.
In
the UK, 74 per cent of homeowners have a fixed rate mortgage for
their home loans, and 96 per cent have chosen this option since 2019,
according to data from UK-based trade association, UK
Finance. AMP
Capital data
shows that Australia has a higher share of mortgage holders with
variable rate mortgages. Just 10-15 per cent picked fixed rates
before 2020 (although this rose to 40 per cent in 2020-2021).
While
variable rate mortgages can be a great option when interest rates are
low in the short-term, fixed rate mortgages can be more predictable
over the long-term, as they are less impacted by interest rate rises
that can raise overall home loan repayments.
“What
we see in the US or Europe is not necessarily what we will see here,”
Dr Romero Cortés says. “The US Federal Reserve (Fed) or the Bank
of England are also effectively trying to slow down the economy, but
when they raise their rates, they can't reach a large portion of
homeowners that have a 30-year fixed rate mortgage.
“The
Fed and the Bank of England can raise cash rates all they want –
they are not reaching these homeowners.
“In
Australia, our increases from the RBA pass through the banks almost
instantaneously to the consumers,” she explains. “There is a
slight delay because banks want to give borrowers as much time as
possible to budget in an increase, but that rate does flow through
almost automatically in a way that's much faster here than you'll see
in countries like the US and UK.”
This
means, faster possible cooling impacts on the economy with the RBA
puts interest rate hikes in place.
Another
big factor is that the big four Australian banks are highly
capitalised.
“They
are flush with cash,” explains Dr Romero Cortés. “I study the
financial network in Australia, and it is very sound. We won’t see
the kind of crisis that we saw in the US in 2008, where the banks
were holding assets that they didn't understand the underlying worth
of.”
What
does that mean for mortgage stress and the Australian economy?
Dr
Romero Cortés say that while lifting of interest rates might mean
Australia will see mortgage stress rise faster than in other places,
it is this situation that helps the RBA prevent the economy from
“running red hot” and collapsing in on itself.
“Like
any central bank, the RBA wants to ensure price stability, and they
will do whatever it takes to prevent us from losing this. They don’t
want consumables like bread and eggs to suddenly be seven times as
much the next day. If that happens people will revolt, effectively.
“We're
nowhere near there. But that's why we don't want to get anywhere near
there. So, the RBA stay very much on top of this, and their role is
to keep this issue as front and centre of the Australian public for
as long as they need, so they are more cautious with their spending
over a longer period of time.”
It’s
in this way that the RBA plays a psychological stabilising role, not
just a financial one.
“You
know, ‘Okay, the RBA is on this: so, I don't need to freak out’,”
says Dr Romero Cortés. “Because if you as a member of the
financial public start freaking out, you’re more likely to make
poor financial decisions which have more of a domino effect on the
wider economy.”
Having
said that, there is a limit to how much financial stress homeowners
can undergo.
"There
could be a point where homeowners and others can't withstand the
raising of monthly repayments any longer,” she says. “This is not
yet the case.
“Long
term, you would expect some sort of horizon where things settle
around 4 or 5 per cent cash rate. Australia is highly leveraged
(meaning it has an on average high level of debt to equity), so more
than that would be difficult to sustain.”
Banks
don’t want to see mortgage defaults
At
the end of the day, lenders don’t want homeowners to default on
loans or to proceed with a repossession. It’s costly, in time,
effort and capital for them, says Dr Romero Cortés. They would much
rather work with the borrower before they get to that point of
extreme financial difficulties.
“A
homeowner in financial stress would contact your bank, who would
require some documentation of financial hardship, and then would work
with you either in a payment plan or deferral plan, refinancing or
making interest-only payments.”
Remember:
you're not getting out of it. You still pay it, the interest is still
accruing, and it could lengthen the loan term. All this means that
borrowers are going to consume less in other places, and therefore is
supposed to lead to a ‘cooling’ of the economy.
What
happens if cost of living doesn’t come down?
But
if living here gets too hard and expensive with inflation or higher
mortgage repayments, you could see Australia reputation as ‘a good
place to live’ take a hit, pushing down the number of people who
want to live here, and putting further pressure on an already tight
labour market, says Dr Romero Cortés.
For
example, a portion of all the Australians with overseas heritage
might decide Australia is too hard and expensive to live in and move
to their other country of citizenship. That’s when it might start
to get uncomfortable.
"Australia
has an economy that's built up by people wanting to come to
Australia, and we’re constantly growing in that fashion,”
explains Dr Romero Cortés. “There's demand for housing, education,
and we currently have people willing to come here.
“So,
the government can say whatever they want about the RBA [and their
decision to raise rates] so they will get voted in again. But the RBA
doesn’t have a choice: one family defaulting on their mortgage,
compared to everyone not being able to afford bread, is what they are
envisioning.”
Does
all this mean house prices will come down more?
Higher
mortgage repayments could pressure homeowners to accept lower sale
prices than they might have expected from their property, investment
or otherwise; nudging down overall prices on the property market over
a period of time, as well as the occasional ‘fire sale’.
“Are
you going to see a massive crash of house prices where you see a
Bondi four-bedder going for $500,000? No.
“But
we could see a small depression in prices where 5 to 10 per cent of
the price is cut. Even if you cut off 10 per cent from a $2 million
home, that's $200,000 less. This means unless they have to, sellers
are not going to want to sell.”
All
this means it is true you're going see some very high mortgage
payments and additional cost of living pressures as homeowners
prioritise their mortgage repayments, Dr Romero Cortés points out.
“It’s
also true that politicians (who are complaining about the RBA’s
approach) may
be among those who own a lot of investment properties themselves.”
Dr
Kristle Romero Cortés is an Associate Professor in the School of
Banking & Finance in the Business School at UNSW Sydney, an
expert in real estate economics and formerly worked at the Federal
Reserve Bank of Cleveland.
