The huge increase in dwelling prices was made possible by ultra-low interest rates. Now the prospective rise in interest rates is likely to have a much bigger impact on many borrowers future living standards than previously experienced, and the demand for rental accommodation is also likely to increase faster than in the past.
Yesterday’s article discussing living standards concluded that over the last two years although real wages fell during the Covid pandemic, a broader measure of real household disposable incomes per capita shows a substantial improvement in living standards. This probably means, however, that there was quite a lot of disparity in the experience of different households.
Looking to the future this disparity is likely to continue, although possibly for different reasons. In particular, housing affordability is deteriorating substantially for some, mostly younger, households, and this is the focus of this follow-up article today.
The increase in housing prices
As is well known interest rates fell to unprecedently low levels as part of the economic response to the Covid pandemic. One (possibly unforeseen) consequence of these ultra-low interest rates was soaring dwelling prices.
According to the data collected by CoreLogic, in the five major capital cities home values increased by 20.6 per cent over the twelve months to the end of January this year. The increases were, however, significantly greater in Brisbane (29.7 per cent), Adelaide (25.2 per cent) and Sydney (24.6 per cent).
As at the end of March 2022 the median dwelling value nationally was $738,975, and $818, 307 for the combined capital cities, but as much as $1,116,869 in Sydney (see Table 1).
This national median dwelling value of almost $740,000 is 14.4 times the median household disposable income of $51,000 a year, and 11.9 times the median wage of $62,400 a year. Obviously, most people could never have afforded to pay these prices for dwellings in most of the capital cities if mortgages had not increased commensurately, and the increase in the size of a typical mortgage would in turn have not been possible without the extra-low interest rates.
But is this situation sustainable, and what are the implications for dwelling prices and living standards if it is not?
At present the cash rate set by the Reserve Bank is at an historic low of only 0.1 per cent. Market economists expect, however, that it will rise to 1.25 per cent by the end of this year, and financial markets are presently pricing the official cash rate at 3.3 per cent by the end of next year. These increases in the cash rate are bound to be passed on into mortgage rates of interest.
In that case, it is estimated that a full percentage point increase in mortgage rates would add almost $500 a month to repayments on a $600,000 loan. An increase in the cash rate to 3 per cent would increase these repayments by $1500 a month or nearly $400 a week.
Thus, for many households, the prospective increase in interest rates will dwarf the impact on their living standards from petrol prices on the one hand and a pick-up in wages growth on the other.
Of course, not all households will suffer from the prospective increase in interest rates. Older people tend to own their houses outright, and many mortgagees are ahead in paying down their mortgage, so they can postpone any increase in their repayment rate.
According to the Reserve Bank, around 60 per cent of all borrowers currently have variable-rate loans, and just over 40 per cent of these borrowers who are owner-occupiers made average monthly repayments over the past year that would be large enough to cover the increase in repayments if mortgage rates were to increase by 2 percentage points.
At the other end of the spectrum, however, if mortgage rates increase by 2 percentage points, around 25 per cent of variable-rate owner-occupiers would see their repayments increase by more than 30 per cent of their current repayments. In addition, the share of these borrowers facing a debt servicing ratio greater than 30 per cent (a high repayment burden) would increase from around 10 per cent to just under 20 per cent.
The situation is not quite as dire for fixed-rate borrowers, but most of these loans will expire during the next two years. Assuming interest rates increase by 2 percentage points, a bit more than a third of these fixed-rate borrowers will then find that their minimum repayments have increased by more than 20 per cent.
In sum, it seems highly likely that a substantial proportion of homeowners will experience a major drop in their living standards. Indeed, some homeowners will find it difficult to service their mortgages in a year or two’s time and will be forced to sell.
Reserve Bank modelling finds that these forced sales are likely to lead to housing prices falling by around 15 per cent over the next two years if, as is likely, interest rates increase by two percentage points. Unfortunately, the interest rise might well be even greater and the consequences thus worse.
But not all homeowners will suffer equally. Rather the pain will be concentrated among first-time home buyers, who will mostly be young couples. Older people, who own their home outright will still be substantially richer than they were a few years ago.
The impact on renters
This increase in house prices is also impacting people who rent. First, the number of people seeking to rent has increased substantially now that it is more difficult to afford home ownership. Not surprisingly, this has pushed up rents with Australian rent values increasing by 8.7% in the year to March,, down from a recent cyclical high of 9.4% in the 12 months to November.
These increases in rents are much higher than the increase in most households’ incomes. Low-income renters are especially hard hit, with more than half spending more than 30 per cent of their incomes on rent.
Furthermore, this rental stress may well get worse. During the two years of Covid the rate of population growth was unusually low and net migration was even negative, but this is not expected to last, and as population growth returns to normal the upward pressures on rents will increase further.
An increase in rent assistance should therefore be a high priority if we are genuinely concerned about future living standards. But there was nothing in the Budget for renters. Instead, the Budget offered a six-month halving of fuel excise, although Australians only spend 3 per cent of their incomes on petrol, while renters spend more than 10 times as much on rent.
Conclusion
Overall Australia did well in protecting living standards through the pandemic. However, living standards were stagnating before, and as discussed in yesterday’s article, the Budget forecasts for future wage growth look optimistic.
In addition, the likely future rise in interest rates poses a major threat to living standards for many households. Young first homebuyers are especially likely to experience a severe drop in their finances after they have serviced their mortgage.
Also, more people will be forced to rent as homeownership becomes unaffordable, and the consequent rise in rents is also likely to outstrip the rise in household disposable incomes. Many low-income households are already experiencing rental stress, and this is likely to worsen.
In some respects this deterioration in many (but not all) peoples’ living standards is inevitable. But the extent to which interest rates rise will be heavily influenced by the Government’s fiscal policy, and as discussed in another article, the outlook for budget deficits will put upwards pressure on interest rates in the years to come.
Frankly Australia can and should do better, but this will never be possible so long as we maintain the mantra of lower taxes.
Michael Keating is a former Secretary of the Departments of Prime Minister and Cabinet, Finance and Employment, and Industrial Relations. He is presently a visiting fellow at the Australian National University.
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