Banking & Lending

Monetary policy Much-hyped concerns that people rolling off cheap fixed-rate home loans could be caught up in a wave of defaults and mortgage arrears have so far proved overblown.

Households and the domestic financial system look well braced to withstand the 4 percentage points of interest rate increases so far, amid the possibility of more monetary policy tightening by the Reserve Bank of Australia.

The exaggerated fixed-rate mortgage ‘‘cliff’’ has turned out to be a manageable staircase for borrowers graduating from super-cheap fixed loan rates of about 2 per cent to variable mortgage rates of 6 per cent or so. While there is a painful financial squeeze on a subset of borrowers, there is little evidence to suggest monetary policy is biting households in aggregate too hard.

If anything, the RBA’s Financial Stability Review published last Friday should give the central bank confidence that it can lift interest rates further if underlying inflation proves more persistent than hoped when the September-quarter consumer price index is published on October 25.

Much-hyped concerns that people rolling off cheap fixed-rate home loans could be caught up in a wave of defaults and mortgage arrears have so far proved overblown.

Banks issued about $400 billion of fixed-rate mortgages in 2020 and 2021. Ultra-cheap fixed-rate loans were turbocharged by the RBA’s $188 billion term funding facility (TFF) offering loans to commercial banks for three years at rates of 0.1 per cent to 0.25 per cent.

The stock of housing credit outstanding with fixed-rate loans doubled to almost 40 per cent and the flow of fixed-rate home loans was even higher.

Now, about half of the loans by value have rolled off onto higher interest rates, with the vast majority of borrowers opting for variable-rate loans. The peak of the roll-off passed in the June and September quarters. Most of the remaining cheap fixed-rate loans will expire over the next 12 months.

‘‘The majority of current fixed-rate borrowers are estimated to have sufficient income to continue meeting their obligations after moving onto higher mortgage payments,’’ the RBA notes.

‘‘The majority also have large savings buffers,’’ the review says. ‘‘Fixed-rate loans yet to roll off do not appear materially riskier than those that have already rolled off.’’

The RBA won’t be surprised the apocalyptic mortgage cliff has failed to materialise.

Historically, fixed-rate borrowers were a bit riskier than variable-rate borrowers. But during the pandemic, a large new cohort of fixed-rate borrowers emerged to take advantage of the very low rates.

Hence, fixed-rate borrowers closely resembled typical variable borrowers. The performance of fixed and variable rate borrowers converged.

Many borrowers used the low rate era to build up extra savings and get ahead on their mortgage. Of the remaining fixed rate owner-occupier borrowers, about two-thirds have liquid savings equivalent to at least 12 months of scheduled mortgage payments – similar to variable-rate owner-occupier borrowers.

Fewer than 20 per cent of fixed-rate borrowers who will roll off onto higher interest rates have much lower savings buffers, equivalent to less than three months of scheduled mortgage payments. This is the tail the RBA will be keeping a close eye on.

Unsurprisingly, arrears rates for all loans were higher for borrowers with high ratios of loan to value (LVR) or loan-to-income (LTI), and moderately higher for first home buyers.

As long as unemployment stays relatively low, most borrowers will navigate the squeeze. The August jobless rate was unchanged from July at 3.7 per cent.

To be sure, the impact of interest rates on households is very uneven. For low-income households that have a mortgage (many rent), the lowest income quartile are devoting an average of 43 per cent of their income to mortgage payments, compared to just 8 per cent for the top income quartile.

It won’t surprise the RBA that the unfortunate side effect of monetary policy is distributional consequences. Monetary policy is a blunt tool that operates at the margin to squeeze household cash flow.

Paradoxically, low-income households (with and without a mortgage) have recorded a big increase in real employment income of between 5 and 10 per cent over the year to June 30, even discounting for inflation. Higher-income households have recorded a bigger squeeze.

The surprising dichotomy is because the employment earnings of low-income people are more cyclical and tied to the performance of the labour market.

In the hot labour market of the past couple of years, low-income earners have been able to secure more jobs and hours. But as the economy slows and unemployment edges higher, these marginal workers are most likely to be the casualties.

Hence, the RBA is trying to navigate a soft landing to retain employment gains since the pandemic, while trying to gradually reduce inflation.

Financial stress is creeping in for a small minority of borrowers. Since May, required household mortgage payments – interest plus scheduled principal repayments – have risen from about 7 per cent of household disposable income to almost 10 per cent.

About 5 per cent of variable-rate owners-occupiers are earning income that is less than their combined mortgage payments and essential living expenses, up from 1 per cent in April 2020.

Including broader ‘‘essential’’ items such as private health insurance and school fees, 13 per cent are in negative cash flow.

Households in Melbourne and Sydney, where borrowers take on more debt because of high house prices, are being stretched a bit more.

Nevertheless, the negative cash flow does not necessarily indicate acute mortgage stress because some of these borrowers have savings or are ahead on their mortgage.

Slightly more borrowers are dipping into their household savings in offset and redraw accounts – but only about 15 per cent, compared to about 11 per cent six months ago. In aggregate, households are still adding to savings, albeit at a slower pace.

The question on the minds of commercial bankers is what happens if the RBA increases the cash rate beyond 4.1 per cent. Households have already tightened their belts and some have very limited capacity for a further round of spending cuts.

Besides tackling the primary goal of underlying inflation, another related factor the RBA will need to consider is the surprise continued growth in house prices. The ‘‘wealth effect’’ could cushion weak consumer spending and challenge its plan to reduce the 5.2 per cent inflation rate to the 2 per cent to 3 per cent target by 2025.

Hence, the last mile of the inflation fight will be the most challenging for the RBA and households.

John Kehoe is The Australian Financial Review’s economics editor.

The already-record share of income households spend on mortgage repayments will increase even further, the Reserve Bank has warned, causing borrowers to dip into savings to meet the rising cost of living.

Surging home loan repayments were successfully reducing household spending and helping the central bank get inflation back to target, Chris Kent, the RBA’s assistant governor for financial markets, said in a speech yesterday.

But Dr Kent said the RBA would likely respond to any evidence that inflation was not on track to return to the central bank’s 2 per cent to 3 per cent target by December 2025 with another interest rate rise.

‘‘We’ve made it pretty clear we would be not wanting inflation to take much longer,’’ Dr Kent said, pointing to a significant upward price shock as a potential trigger for a 13th cash rate increase.

The RBA has cited the strength in interest rate pass-through as a reason for leaving the cash rate on hold at 4.1 per cent since June, as the central bank assesses the cumulative effect of its 12 cash rate rises since May 2022.

On Tuesday, International Monetary Fund analysis showed households in Australia devoted a greater share of their income to mortgage repayments than in any other advanced economy.

Dr Kent said scheduled mortgage repayments had risen to almost 10 per cent of disposable income from 7 per cent since the RBA began lifting rates from a record low 0.1 per cent 17 months ago. These figures include households without a home loan.

‘‘This is above estimates of the peak reached in 2008 when the cash rate was 7.25 per cent,’’ he said.

‘‘And for those households with a large mortgage, required payments are a much higher share of their income.’’

The share of household income spent on mortgage repayments will increase further as borrowers on pandemic-era fixed rate mortgages roll off onto variable rates, which are 3 to 4 percentage points higher. The share of fixed rate credit has already fallen substantially to 20 per cent of all home loans from 40 per cent in early 2022, Dr Kent said.

While high interest rates cool the economy, Dr Kent said the main way they slowed demand was by making mortgages more expensive, known as the ‘‘cash-flow channel’’ of monetary policy.

‘‘Many borrowers have had to cut back on spending to meet higher mortgage payments, while also feeling the pain of rapidly rising living costs. This has led to slower growth in demand for goods and services,’’ he said. Retail sales are in their most prolonged contraction since the global financial crisis, as consumers cut back on purchases of discretionary goods such as furniture and appliances.

The RBA estimates the 4 percentage point increase in the cash rate since May 2022 had reduced overall household spending by about 0.4 per cent to 0.8 per cent per year through the cash-flow channel.

Households accumulated about $300 billion in additional savings during the pandemic, which has provided a cushion to borrowers dealing with rapidly rising interest rates.

However, households had started drawing down on these savings since the start of 2023, RBA analysis shows.

While banks have been under fire for not increasing the deposit rates paid to savers in line with the cash rate, Dr Kent said they had been more generous than their international peers.

Australian banks have passed on about 75 per cent of the 4 percentage point increase in the cash rate since May 2022.

‘‘In New Zealand, for example, the equivalent figure is about 50 per cent, while in the United States it is about 35 per cent.

‘‘Among other things, this difference may reflect Australian banks’ focus on variable-rate borrowing and lending,’’ Dr Kent said.

Dr Kent pointed to the 30 per cent decline in household borrowing capacity since last year and the support provided to the exchange rate from high interest rates as evidence of the contractionary effects of the most rapid tightening cycle in decades.