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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

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.

So how does the Reserve Bank see household finances across Australia in April 2022?

 

Although global financial systems have held up during the COVID-19 global pandemic, by April 2022 the Russian invasion of Ukraine and subsequent risk of financial stress caused by sanctions had become a factor in the international financial equation. Thus far any risk for Australia's economy appears to be considered manageable.

However, with interest rates expected to begin to rise again by June 2022, real wages growth still in what has been an 8 year-long stagnation with no light on the horizon, home insurance rates predicted to rise by more than 10 per cent on the back of widespread flooding on the Australian east coast, a continuing shortage of affordable housing stock with overall housing supply also expected to significantly drop and, annual residential rental growth continuing to rise sharply, the next few years may not be as manageable for some households.

Here are excepts from the Reserve Bank’s assessment of household and business finances.

Reserve Bank of Australia, Financial Stability Review April 2022, Household and Business Finances:

The incidence of household financial stress is low and declining, but a small share of households are vulnerable to cash flow shocks …

The share of APRA-regulated lenders’ non-performing housing loans was just 0.9 per cent at the end of 2021 – lower than before the pandemic (see ‘Chapter 3: The Australian Financial System’). Almost all borrowers who have exited loan payment deferral arrangements available earlier in the pandemic are now up to date with their repayments. The recent strength in employment is likely to have offset the unwinding in fiscal policy support for most indebted households. For the small number of borrowers who are currently experiencing repayment difficulties, liaison with banks indicates that the vast majority had been experiencing problems prior to the pandemic, and that early indicators of financial stress in other borrowers (such as households reducing their prepayments) remain very low.

Households in flood-affected areas of New South Wales and Queensland are facing significant challenges. To alleviate near-term financial challenges, government disaster-relief payments and hardship assistance from lenders have been made available. Recent estimates suggest that the number of insurance claims is higher than following the 2011 Queensland floods and Cyclone Yasi; although, to date, the total value of claims has been lower as fewer homes require rebuilding. Banks direct exposures to the most heavily affected households are small relative to total lending.

More broadly, the small share of borrowers with low liquidity buffers are more likely than other borrowers to have their financial resilience tested if they experience an adverse shock to their incomes or expenses, including through higher inflation. The risks for households with low liquidity buffers are likely to be even higher for those whose payment buffers have been declining (as opposed to low and stable) and for those who also have high levels of debt. The Securitisation data indicate that, for owner-occupiers with variable-rate loans, the overall share of borrowers with a loan six or more times their income and a buffer of less than one month of minimum repayments has declined since the beginning of the pandemic, to just below 1 per cent (Graph 2.4). The share of owner-occupier variable-rate borrowers with low and declining buffers has decreased to around 2 per cent over the same period. Declines in the shares of both groups of vulnerable borrowers are partly due to lower interest rates.

Historically, renters have been more likely to experience financial stress than indebted owner-occupiers. According to the Household, Income and Labour Dynamics in Australia (HILDA) survey, around one-third of renters reported at least one instance of financial stress (such as being unable to pay a bill on time or heat their home) in 2020, compared to one-sixth of owner-occupiers (Graph 2.5). Although renters are unlikely to pose direct risks to the stability of the financial system (as they have less debt), financial stress for renters could translate to repayment difficulties for indebted landlords or pose indirect risks by constraining household consumption and so economic activity. Renters with a combination of low liquidity buffers prior to the pandemic (equivalent to less than one month of disposable income) and high housing cost burdens (rental payments equivalent to more than 30 per cent of disposable income) were much more likely to report financial stress than other households. Around 15 per cent of renters were vulnerable based on this metric in 2020.

Although the value of consumer debt has declined over recent years, there has been strong growth in households using buy now, pay later (BNPL) services. BNPL services are generally a form of short-term financing that allow consumers to pay for goods and services in instalments. It is estimated that the value of BNPL transactions increased by around 40 per cent over the year to the December quarter of 2021, and the total number of BNPL accounts was equivalent to around one-third of the adult population (although some people have more than one account). There have been some increases in the incidence of late payments on these products. However, the value of BNPL transactions remains relatively small compared to other forms of personal finance, with the value of domestic personal credit and charge card purchases on Australian issued cards around 15 times larger than BNPL transactions in the December quarter of 2021.

… including a small share of borrowers who could struggle to service their debts as a result of higher interest rates and/or inflation

….Around 60 per cent of all borrowers currently have variable-rate loans, with around two-thirds of these being owner-occupiers. Scenario analysis using information in the Securitisation dataset indicates that if variable mortgage rates were to increase by 200 basis points:

• just over 40 per cent of these borrowers made average monthly payments over the past year that would be large enough to cover the increase in required repayments (Graph 2.6)

• a further 20 per cent would face an increase in their repayments of no more than 20 per cent

• around 25 per cent of variable-rate owner-occupiers would see their repayments increase by more than 30 per cent of their current repayments; however, around half of these borrowers have accumulated excess payment buffers equivalent to one year’s worth of their current minimum repayments that could therefore help ease their transition to higher repayments

• the share of borrowers facing a debt servicing ratio greater than 30 per cent (a commonly used threshold for ‘high’ repayment burdens) would increase from around 10 per cent to just under 20 per cent.

One caveat is that households’ average monthly mortgage payments over the past year may have been larger than might reasonably be expected going forward, especially as previous spending patterns resume alongside the recovery in economic activity. It is difficult to draw inferences about the capacity of investors with variable-rate loans to make higher repayments, as they tend not to make excess mortgage payments (and other forms of saving are less visible in available data).

Most borrowers with fixed-rate loans are also likely to be able to handle the increases in their repayments when their fixed-rate terms expire. 

Many borrowers have taken advantage of very low interest rates on fixed-rate products in recent years; in late 2021, almost 40 per cent of outstanding housing lending had fixed interest rates – roughly double the share at the start of 2020. Around three-quarters of currently outstanding fixed-rate loans will expire by the end of 2023……

Read the full analysis here.