After enjoying unprecedented interest rate reductions for over 11 years in Australia, the music stopped around 3 months ago, just before PM Albanese’s win. A 25 point (0.25%) official cash rate rise from the Reserve Bank was followed by a further 50 points in June, and yet another 0.5% rise in July. At the time of writing, the cash rate now sits at 1.35%.
Homeowners and investors who were sitting pretty with record-low borrowing rates are now perking up and starting to panic, as rates incline quicker than Tom Cruise doing 10.3 in an F18 fighter jet. This is all happening despite the RBA’s claim in November 2020 that it would not be increasing the cash rate for at least 3 years until 2024, putting everyone in a false state of ease, fueling record property price growth and lifting confidence. This confidence is now unravelling as the RBA throttles the cash rate upwards in a manoeuvre some see as 'too big too late’.
How Interest Rates Rises Can Cause Pain For Australians
Rate rises not only affect borrowers, but all consumers of products and services from businesses with debt on their balance sheets or with directors who have rising personal home loan commitments. As interest rates rise, companies will increase their prices to help keep profit where it needs to be, and if they can’t, they’ll have to live with a smaller profit or find another way to cut costs, such as employment.
Monetary policy 101 dictates that if the price of goods increases above the target 2-3% inflation band, then central banks should raise rates to slow the economy. However, on the back of a soul-crushing 2-year pandemic, the pain being experienced by both personal and business loan holders from these sudden moves risks becoming even more excruciating.
A key driver for this triple dose of rate hikes is the economic data showing a spike of inflation in Australia, similar to what the majority of other developed countries are also experiencing (although thankfully we aren’t as bad as Israel ).
Raising Rates When Inflation Is Rampant
Many business owners are only just getting back up and running after struggling under the weight of lockdowns, rising costs and crippling staff shortages. Now these rate rises stand to impede their hopes of a smooth comeback. The RBA wants to pull the handbrake on the economy, as they try to stem the cost of living through the tightening of spending. One ray of light is our healthy unemployment rate (3.9% in May. The lowest in almost 50 years). There’s plenty of work available for those who want it. To many, increasing interest rates when things are already so tough seems illogical. But it’s a necessary evil to ensure the price of goods and services don’t spiral out of control.
Some argue that historically low interest rates are what caused the inflation we’re seeing now; however, as shown in the graph above, inflation has been consistent throughout the period leading up the pandemic, so that argument is easily rebutted. More likely, the flames of inflation have been stoked by the amount of government stimulus during COVID. Policies like JobKeeper saw some companies receive cash payments even though their sales had increased, which only manipulated the system. All this extra cash injected into the economy has had inflationary consequences.
What’s Inside Inflation Figures And What Does It Mean?
Drilling down into the highest inflation reading since the early 2000s - the 5.1% annual inflation figure from March 21 to March 22 - the cost of transport, fuel, food and dwelling prices are the biggest contributors. Supply chain problems have led to increased shipping and freight costs globally. Locally, labour shortages combined with fuel and utility costs have led to higher costs for meat and vegetables. This is likely to continue if nothing is done about it.
Ask a builder or a developer how they’re feeling right now and you’ll understand just how tough inflation is making life in some industries. Builders have seen their standard profits shrink or turn red on the back of fixed-priced contracts that are often unable to be renegotiated. Gradually, this situation will heal as new contracts are entered into, but product delays and price rises have caused substantial stress to the point that many large building firms have fallen over from the lack of cash buffers to protect themselves. Metricon, Australia’s largest home builder, only just escaped a collapse last month by securing a beefed up working credit facility.
The size and importance of Australia’s construction industry cannot be downplayed; it feeds into so many other industries and employs over 1.2 million Australians. Outside the core construction workers are the thousands of developers who often supplement their modest family incomes by completing projects ‘on the side’ and with developments now more risky, there is likely to be a major flow-on effect on spending in the economy, especially discretionary spending.
Some less cashed-up developers and construction companies rely on pre-sales to get their developments moving; however, with the tightening of bank lending parameters, due to the risk of a 15-20% property correction, the ability to start projects is becoming tougher by the day. Consumers are reluctant to buy an off-the-plan apartment if prices are expected to tumble during the construction, and there is an increasing fog around home loan affordability and approval compared to when interest rates were falling. With the cost of physical building materials going up, it’s expected that, similar to car prices, rather than depreciating (as is usually the case), renovations and new buildings will hold their value, while the land prices may drop.
Who Benefits From Rising Interest Rates?
One of the only winners in an increased rate environment, aside from retirees with larger cash deposits, are first home buyers who have been waiting for a correction in the property market. But the expected drop in house prices of 15-20% towards the end of 2023, and the increasing stock available due to financially stressed borrowers selling, is bittersweet. Interest rate rises mean a more substantial starting monthly repayment is required by the first-time borrowers, compared to this time last year.
A year ago, I finally bought my first home and managed to secure a 2.19% 4-year fixed rate, which, at the time was actually a 0.2% discount compared to the then variable rate. Fast forward 12 months and fixed rates are now more expensive than variable rates. To most borrowers, fixed rates now look scary, rather than a chance to instill certainty with their borrowing structure. Today, the average 4-year fixed principal and interest owner-occupied home loan rate is a whopping 6.00%. That’s 3.81% higher than late 2021.
To put this into perspective, on a $500,000 home loan this is almost $19,000/year in additional interest ($365/week) or $76,000 over the 4-year fixed period! For this reason, there is absolutely no doubt that property prices have to come down, the question is by how much?
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What Interest Rate Rises and Inflation Mean For Mortgage Holders
Consider Refinancing as Interest Rates Rise
As a broker witnessing it all play out, the most obvious threat I see right now is to those stuck on high interest rate structures who have been sluggish to make the move to refinance. For those with home loans that aren’t priced competitively, the time to refinance is now .
Like a game of musical chairs, with your property value and equity shrinking together with your borrowing power, if a move isn’t made soon then it might be too late. Unless you’re on a stable income and you’ve held property over the past 10 years and enjoyed its massive growth, you could benefit from refinancing your home loan.
Re-evaluate Your Borrowing Power
Every bank uses an ‘affordability rate’ to show you can afford your level of borrowing, which is typically 3% above the actual rate you request. As the RBA’s interest rate rises come through, the rate at which the banks assess your borrowing is higher, which directly reduces how much you can borrow from them.
Couple this with the banks’ now heightened scrutiny of debt-to-income (DTI) ratios and you get an even more compelling driver for property prices falling. As borrowers can’t borrow as much, they won’t be able to buy for as much.
Hope on the Horizon for Mortgage Holders
If the economy does officially slide into recession, there’s already some potential green shoots for mortgage holders, as recent inflation data out of the US suggests inflation may have peaked. If the global supply chain woes and energy crises can be brought under control, then inflation in Australia may start to fall into the RBA’s 2-3% target band once again.
This would mean a typical owner-occupied home loan rate won’t surge much higher than 5%, which is where most economists suggest they will be by the end of 2023. There’s so much else at play, however, including the economic fall-out of the ongoing Russian invasion of Ukraine and other geopolitical factors, which could send rates higher.
Keep Calm and Speak to a Mortgage Broker
Our best advice is to save up a cash buffer and start budgeting for 5 to 6% rates ASAP. If you haven’t been stockpiling an emergency pool of offset or redraw funds during the pandemic to see you through this transition from low rates to ‘historically normal rates’, you may have some tough decisions to make to keep your household going. Likewise, if you currently have an ultra-low fixed rate that you set up 2 to 3 years ago, be prepared for a massive upward jolt to your repayments in the coming months. Speak to a broker about what you could get access to if you refinance now.
If you’re sitting on a bank pre-approval, usually valid for 90 days, be very careful as if it lapses and you’re on the cusp of buying, you’ll need to ensure you can still borrow at the same level with the increased affordability rates applied. In basic terms, every 0.50% increase from the RBA means about $2,000 in annual income is required to service every $100,000 portion of a 30 year principal and interest home loan. For example, with a $500,000 home loan, $10,000 a year more in net income after tax will be required to service the same level of debt.
If you’re already showing $10,000 a year in servicing surplus with the bank, you’ll be fine. Otherwise, you may find yourself in some level of mortgage stress. Strap yourself in for another potential 50 point hike in August and more increases throughout the next 12 months – it’s going to be a bumpy ride.
Get in Touch with an Experienced Mortgage Broker
As always, getting the right advice and planning for the future will help to alleviate some of the stress of rising interest rates and inflation. To discuss your current home loan interest rate and what you could do to help reduce your total interest bill, contact me, Steven Whiteside at BlueRock Finance on 0452 246 522 or Steven.Whiteside@thebluerock.com.au .
