In 2019, Australia’s banking regulator, the Australian Prudential Regulatory Authority (APRA), made it easier for people to secure bigger mortgages. APRA did this by easing the ‘stress test’ on new loans when it changed the test to 2.5 percentage points above the lending rate. The previous barometer was 7%. But that absolute rate was considered too stringent when inflation was tame, the economy was lacklustre, house prices were declining, and mortgages rates were only 3% to 3.5%.1
Within a year, the pandemic struck. The Reserve Bank of Australia (RBA) went radical. The central bank cut the cash rate from 0.75% to a record low of 0.1% gave banks $188 billion to lend via a facility, and placed a yield target of 0.25% on three-year Treasury bonds that was later lowered to 0.1%. Into 2021, the RBA said these low rates would last “until 2024 at the earliest”.
People rushed to borrow at rates below 2%, which set the laxer stress test at up to 4.5%. House prices soared and consumer debt to output now stands at 120% of (nominal) gross domestic product. While this is less than 2016’s record high of 129%, the ratio is among the world’s highest.2
Come 2022, inflation accelerated, to the RBA’s surprise. Three-year government bond yields broke through the RBA’s supposed ceiling. In May 2022, when annual inflation was scored at 5.1%, the RBA was forced to raise the cash rate. Nine increases later, the rate sits at 3.6%, an 11-year high.
Yet inflation remains unbeaten – at 7.4% in the 12 months to January. When the RBA lifted the cash rate in February and March, it warned of more increases. Many analysts expect this benchmark for mortgage rates to top 4% this year.
Australia’s biggest economic threat now centres around the housing market but any crisis would really be about consumer debt. Over coming months about 800,000 households will come off low two-year fixed-rate mortgages, some below 1.75%. These Australian homeowners will assume a variable rate of up to about 6%. A variable rate of 6% adds about $1,320 to the monthly repayments on a 25-year loan of $600,000, compared with a 2% charge.3
RBA analysis in October 2022 showed that owner-occupiers paying variable rates comprised about 40% of the outstanding housing credit and have an average mortgage of $600,000. About 50% of these households would see spare cash flow (income minus mortgage repayments) dive by more than 20% if the cash rate were to reach 3.6% – where it is now. This could reduce consumer spending which is the main driver of economic growth and employment.
About 15% of owner-occupiers, typically low-income households with large mortgages, could suffer negative cash flow, according to the RBA analysis. If they were to lack savings, they might default, be forced to sell their homes, or have to renegotiate (extend) their loans.4
Household consumption forms about 55% of GDP. Australia’s economy could be challenged in 2023 if consumer spending contracts. If the economy falters, blame the debt consumers have been allowed to, even encouraged to, amass.
To be sure, loose monetary policy helped protect the economy from the pandemic and the RBA low-rates assurances helped here. Plus, these RBA pledges were qualified. The jobless rate is near a 50-year low and is not expected to soar and trigger the mortgage torment that would torpedo the economy. Higher commodity prices are also supporting the economy. Household balance sheets are in “strong shape”, to quote the RBA. Savers are enjoying higher deposit rates.
But the handicap of monetary policy is that to slow inflation it needs to pummel the one-third of households with mortgages. That could have wider repercussion that could even trigger Australia’s first recession since 1991.
Debt Challenge
Australian households with mortgages may be struggling even though interest rates are low by historical standards. This highlights the risk that high consumer debt poses for any economy. When the cash rate reached a record 17.5% in 1990 prior to the 1990-91 recession, Australia’s household debt was only about 50% of nominal GDP.5
When household debt is high, interest rates don’t need to reach double figures to stretch households because the percentage of income consumed by repayments is higher. The Grattan Institute in June last year estimated that a mortgage rate of 7% could be as devastating as those approaching 20% that were experienced in the 1990s.
A variable mortgage rate of 6% today would ensure that mortgage repayments consume about 11% of Australian disposable household income, almost double the 6% of disposable income repayments in 1990 when variable rates topped 18%, the institute says. This reflects that people these days borrow more against their income to buy a home than did their parents because housing costs more.6
The greater punch of interest-rate rises means it’s harder for the RBA to calibrate the increase in the cash rate needed to manage the economy.
While borrowing helps people smooth the cost of consumption over time and there’s no definitive point where the ratio of consumer debt to output is poisonous, too much consumer debt can pose a systemic threat. It’s clear that it’s risky to ease the stress test on mortgages and for a central bank to tell borrowers rates will be low for years.
ENDNOTES
1The Australian Prudential Regulatory Authority. ‘APRA finalises amendments to guidance on residential mortgage lending.’ APRA media release. 5 July 2019. apra.gov.au/news-and-publications/apra-finalises-amendments-to-guidance-on-residential-mortgage-lending. See also ‘APRA’s home loan rule relaxation will allow for bigger mortgages.’ ABC News. 5 July 2019. abc.net.au/news/2019-07-05/apra-relaxes-mortgage-lending-restrictions/11282066. In October 2021, APRA raised the guidance to 3 percentage points over the mortgage rate.
2Nominal GDP is output calculated at prevailing prices. CEIC. ‘Australia household debt: % of GDP.’ The ratio reached a record high of 129.4% of GDP in 2016. ceicdata.com/en/indicator/australia/household-debt–of-nominal-gdp. See Reserve Bank of Australia ‘Why is Australian household debt high relative to history and other countries?’ August 2020. rba.gov.au/publications/rdp/2020/2020-05/why-is-australian-household-debt-high-relative-to-history-and-other-countries.html
3RateCity mortgage calculator. Monthly repayment at 2% is $2,543 (principal and interest). At 6%, the monthly repayment jumps to A$3,866. Over a year, the increase is A$15,852 (after tax). ratecity.com.au/
4Reserve Bank of Australia. Financial Stability Review – October 2022. ‘Box B: The impact of rising interest rates and inflation on indebted households’ cash flows.’ rba.gov.au/publications/fsr/2022/oct/box-b-the-impact-of-rising-interest-rates-and-inflation-on-indebted-households-cash-flows.html
5CEIC. Household debt to nominal GDP was as low as 44.8% in 1988.
6Grattan Institute. ‘The housing game has changed – Millennials have it harder.’ Joey Moloney and Brendan Coates. 7 June 2022. grattan.edu.au/news/the-housing-game-has-changed-millennials-have-it-harder/
