Interest Rate Hikes Hurt Borrowers More Than Before

The Reserve Bank has lifted the cash rate for the second time in two months, this time by 0.50 points to 0.85 per cent.

It won’t be the last such hike. Forecasters expect the cash rate to hit 2.5 per cent by the end of next year. This would lift the typical variable mortgage rate to near 5 per cent.

Cue the claims that the new generation of borrowers are entitled—they don’t know how good they’ve had it with such low rates.

But the refrain misses the full story. High house prices have changed the game, making it much harder for today’s borrowers.

It is true that even a mortgage rate of 5 per cent is well below the peak of about 17 per cent earlier generations paid at the start of the 1990s.

But the impact of those high rates on overall mortgage interest payments as a share of income was modest, because house prices were much lower then, and mortgages were much smaller.

Typical house prices used to be about four times incomes. Now they’re more than eight times incomes, and more in Melbourne and Sydney.

This has meant that for any given mortgage rate, the share of income taken up by mortgage payments is much, much higher.

If you have a small loan with a high rate, all you need is a cut in rates, some inflation and decent income growth, and your mortgage burden can fall sharply.

That’s how it was for borrowers in the 1990s. High rates stung, but not for long.

Borrowers in the 1990s who started out devoting more than 30 per cent of their income to paying off a mortgage found themselves devoting just 12 per cent by the time the loan was halfway through.

It’s different if you’ve borrowed recently.

▲ The extraordinary increase in house prices and debt means mortgage rates of 7 per cent would be as painful to borrowers today as rates of 17 per cent were decades ago.

If you’ve taken out a big loan at today’s ultra-low interest rates, there’s only one way your mortgage payments can go—and that’s up.

Even if mortgage rates stabilise at around 5 per cent—which is implied by some of the things the Reserve Bank governor has said—and wages grow faster than they have for a decade, the mortgage burdens of millennials who’ve bought houses recently won’t decline much..

The extraordinary increase in house prices and debt means mortgage rates of 7 per cent would be as painful to borrowers today as rates of 17 per cent were decades ago.

It’s a common barb that newer generations are struggling with home ownership and housing costs because of profligate spending, on smashed avos and the like.

But millennials spend less of their incomes on “discretionary” items—such as alcohol, clothes and household services—than people of the same age did decades ago.

What millennials are spending much more on is housing, simply because houses are so much more expensive.

So as the Reserve Bank continues to increase rates, it’s important to keep in mind that comparisons between then and now miss the full story.

Skyrocketing house prices have changed the game. For millennials, even historically small increases in interest rates will hurt.

Authors

Joey Moloney,
Senior Associate, Grattan Institute

Brendan Coates,
Program Director, Economic Policy, Grattan Institute

This article is republished from The Conversation under a Creative Commons license. Read the original article.