‘Living in mortgage hell’: tens of thousands of borrowers on the brink

A higher than expected inflation report has really set the cat among the financial market pigeons as 2023 kicks off, with markets now pricing another three interest rate hikes this year.

To which I say: steady on, fellas.

RBA governor Philip Lowe may have less room to move on rates than many realise.Credit:Alex Ellinghausen

Yes, it’s likely Reserve Bank governor Phil Lowe will return from his summer holidays to signal his inflation-fighting credentials by delivering yet another hike at the bank’s first meeting of the year next Tuesday.

However, we are already much closer than many assume to the limits of how far Lowe can go in the bank’s fight to contain rising prices.

You see, Australia’s mortgage market is unlike almost any other in the world, boasting one of the highest rates of variable interest loans. In the US, for example, most borrowers are on 30-year fixed interest rate loans, meaning rapid rate hikes only impact new borrowers and can be delivered in rapid succession.

In Australia, by contrast, an unusually high proportion of mortgages are written on variable rate terms, meaning rate changes hit hip-pockets in a powerfully direct way.

It’s true that during COVID, many Aussie borrowers took up the likely once-in-a-lifetime opportunity to fix their interest rate below 2 per cent. However, these were only for two or three-year periods and most are expected to expire this year, resetting to much higher variable rates.

And things are even more precariously poised than that, thanks to several changes to relax borrowing rules just before the onset of COVID.

It’s a long story, but in late 2019, our prudential regulator relaxed the “serviceability test” lenders must apply to new home loans. This enabled borrowers to load up with even more debt than before.

Previously, lenders had to test your cash flow (income minus expenses) to make sure you could still keep up with your minimum mortgage repayments if interest rates surged to 7.25 per cent.

That “buffer”, however, was relaxed to just 2.5 percentage points above the prevailing interest rate. As interest rates plunged during COVID, particularly on fixed rate loans, the hurdle for new borrowers to service a loan amount fell dramatically.

These borrowers are already getting caught out – big time – as rates rise.

Our official cash rate is already a full 3 percentage points above its all-time lows. Get it? Anyone who borrowed at the very bottom of the rates cycle and was stress-tested under the old 2.5 percentage point rule is already underwater.

Many of these borrowers must already be living in mortgage hell – a situation where they do not have enough income left, after expenses, to pay the mortgage.

I’ve previously calculated that 155,431 first home buyers took out loans during this period when the cash rate was at its lowest and before the stress test was increased to 3 percentage points in late 2021.

For borrowers who borrowed at the bottom of the rates cycle but were stress-tested under the slightly higher rule, they, too, must only be treading water.

Worst-case scenario, these borrowers may default on their repayments and, in due course, have their homes re-possessed. Such forced home sales would add to property price falls.

However, for the vast majority, it’s likely things won’t turn out that badly.

It’s possible many recent borrowers did not actually borrow to the maximum they were allowed, while others may have cash savings buffers to draw on to meet repayments in the short term.

Many will find other ways to cope, such as increasing their income by taking on side hustles, second jobs, or switching to more highly paid jobs in a red-hot jobs market.

Spending can also be cut. Although, it must be said, the assumptions lenders are required to make about borrower spending in the loan application process already assume a fairly humble lifestyle.

For borrowers with no backup options, hardship arrangements can be entered into with lenders. Loans can be made “interest-only” for a time. As any banker will tell you, it’s a fairly protracted process to actually repossess a home in Australia. And it may be in the interest of banks to help keep borrowers afloat, given that – particularly on recent purchases – money recovered through sales may not even cover the debt.

So, while distressing indeed for individual borrowers, I don’t think it’s likely we’ll see a big rise in forced home sales having a big impact on property prices Australia-wide. But it’s certainly something for the Reserve Bank to keep a close eye on.

It’s also unclear how spending will be affected as households on ultra-low rates roll off onto much higher variable rates throughout 2023. If they’ve failed to adjust spending in advance, it’s likely we’ll see large drop-offs in spending by such households and a much softer economy.

So, as we look to predict interest rate movements in 2023, it’s important to keep in mind both the distinctive features of our recent mortgage market relative to other countries and also relative to other periods in our history.

Now more than ever, there are very good reasons for our Reserve Bank to tread very cautiously in raising interest rates further.

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