Skip to navigationSkip to contentSkip to footerHelp using this website - Accessibility statement
Advertisement

Borrowers face buffer wipeouts from rate rises: RBA

Updated

Subscribe to gift this article

Gift 5 articles to anyone you choose each month when you subscribe.

Subscribe now

Already a subscriber?

The Reserve Bank of Australia has warned that tens of thousands of borrowers on variable-rate mortgages will wipe out their buffers within six months if interest rates rise in line with market forecasts, even if households dramatically cut their spending.

About 8 per cent of borrowers would completely drain their mortgage prepayments within months if the official interest rate rises to 3.6 per cent in the next year, even if they slashed their discretionary spending by 80 per cent, the RBA’s biannual Financial Stability Review shows.

Twenty per cent of homeowners are facing an increase in mortgage payments to 30 per cent of their income. 

Low-income households and recent first home buyers are the most at risk of mortgage stress as they are the most likely to have smaller prepayment buffers and less discretionary spending to draw down on.

The RBA on Tuesday raised the cash rate by a quarter percentage point, its sixth, consecutive increase, taking it to 2.6 per cent since May. Financial markets are betting it will peak at 3.6 per cent in June next year.

The 250 basis point, or 2.5 percentage point, increase since early May is important as it was the mandated serviceability buffer used for almost 200,000 first home buyers between September 2020 and October 2021.

Advertisement

Although the central bank says the financial system is in a strong position, the RBA’s analysis showed painful times are ahead for many borrowers.

“Higher interest rates and inflation will slow aggregate household consumption and the pace of economic growth more broadly, but the direct financial stability risks posed by vulnerable borrowers appear modest,” the RBA’s semi-annual health check of the financial system said.

“A large increase in unemployment combined with a historically large decline in housing prices would pose a more material risk to loan arrears and defaults, and therefore financial stability.”

After 2.5 percentage points of interest rate increases, 40 per cent of variable rate borrowers will not have to increase their mortgage payments and 15 per cent will not have an increase in payments of more than 20 per cent.

But 20 per cent – one in five – will face an increase in mortgage payments to 30 per cent of their income.

Advertisement

If interest rates increased to 3.5 per cent in line with market forecasts, 25 per cent of all variable loan borrowers would have to pay 30 per cent of their income on mortgage payments. That figure could be higher if the jobless rate rises and wages do not increase “as expected”.

Variable-rate home loans account for 65 per cent of outstanding mortgage credit. But the looming risk is how a wave of borrowers that took out ultra-low, fixed-rate loans will fare as two-thirds are scheduled for refinancing before the end of 2023. They will then face a jump of between 3 and 4 percentage points in interest rates.

If interest rates rise as projected, 60 per cent of borrowers will face a 40 per cent increase in payments. The central bank acknowledges there is “limited information to assess whether fixed rate borrowers will experience difficulty with these increased minimum payments” as there is no visibility as to the extent of their savings.

Although much of the analysis focused on borrowers, the RBA said renters would face acute strains from higher payments and increased inflation, and there were indications that some businesses were being pressured by rising costs and higher interest rates – particularly in construction, transport and education.

Cash squeeze analysis

As part of its review, the Reserve Bank conducted detailed scenario analysis of how household cash flows would withstand the hit of higher inflation and rising interest rates.

Advertisement

“Although most households are likely to be able to weather increased pressure on their finances for some time, many will need to curtail their consumption and could ultimately see their savings exhausted.”

The analysis said half of variable loan borrowers would see their spare cash decline by more than 20 per cent and 15 per cent would experience negative cash flows.

Some households, it said, would struggle to keep up to date on mortgage payments. About half of all variable borrowers could meet payments and essential expenses for two years by drawing down on their buffers. If households were to cut back non-essential spending by 20 per cent thr proportion of households that could meet expenses for two years rises to 70 per cent.

Worryingly, the RBA said 8 per cent of owner-occupied, variable-rate borrowers would “fully exhaust their prepayment buffers within six months” even if they cut non-essential spending by 80 per cent.

About 40 per cent of these borrowers are in the lowest quartile of income distribution.

Leading indicators flashing

Advertisement

The RBA said that as yet there were limited signs in the official data of financial stress. But leading indicators were flashing. These include household surveys, increased Google searches relating to stress, and negative press reports that the RBA said “have historically borne some relationship with loan arrears”.

The bank’s liaison program also reported increased demand for social and community services such as low-cost housing and goods.

The Reserve Bank has often referred to the fact that the median home loan borrower has 22 months of buffers saved up. But it said the increase in interest rates had shaved two months of this measure since April.

“Recent borrowers are more vulnerable to debt servicing challenges and default in a rising interest rate environment as they have less time to accumulate liquidity and equity buffers”

Its securitisation dataset said about half of home buyers who took out a loan since 2021 have less than three months prepayment buffers. These borrowers also have the highest loan-to-value ratio loans while their greater level of indebtedness makes them more sensitive to interest rate increases.

House prices take a hit

Advertisement

The sharp increase in interest rates has raised concerns about the implications for Australia’s property market. Last month, the Reserve Bank’s Jonathan Kearns warned that homeowners in expensive suburbs should brace for the biggest declines in value.

In its April Financial Stability Review, the bank said house prices could fall by 15 per cent if interest rates increased with market expectations.

That was before the RBA lifting interest rates above its 0.1 per cent emergency setting. On Thursday, economists at National Australia Bank forecast a 20 per cent peak-to-trough fall in house prices with the full hit from interest rate rises yet to be felt by borrowers.

Friday’s document did not detail any analysis on house prices.

But it comes about a week after the Bank of England was forced to intervene in the gilts market as pension funds faced margin calls on interest rate derivatives that threatened to overwhelm its financial markets. The rapid scramble for cash has been felt in Australia as UK funds have sold almost $1 billion of Australian asset-backed securities while ASX-listed fund Magellan was hit with a big institutional investor redemption.

The Reserve Bank laid out three main risks to financial stability pressuring cash flows and asset values. One was that financial conditions could tighten further if inflation proves more persistent.

A second risk was that defaults could accelerate, weakening the balance sheets of banks, and third threat has become more pertinent – cyberattacks that could undermine confidence in financial institutions. This, it said, was a point “underscored by the recent attack on Optus.”

“It is probable that a significant financial institution or market infrastructure will be subjected to a successful attack at some point given the increased sophistication and frequency of cyber-attacks,” the RBA said.

Jonathan Shapiro writes about banking and finance, specialising in hedge funds, corporate debt, private equity and investment banking. He is based in Sydney. Connect with Jonathan on Twitter. Email Jonathan at jonathan.shapiro@afr.com
Ronald Mizen reports on the intersection of politics, business, economics and the law from Parliament House, Canberra. Connect with Ronald on Twitter. Email Ronald at ronald.mizen@afr.com

Subscribe to gift this article

Gift 5 articles to anyone you choose each month when you subscribe.

Subscribe now

Already a subscriber?

Read More

Latest In Economy

Fetching latest articles

Most Viewed In Policy