Incremental home loan interest rate hikes have been eating into the household budgets of millions of Australians ever since the Reserve Bank of Australia (RBA) began lifting its official cash rate in May 2022.

This month the RBA decided to leave its cash rate unchanged at 3.60 per cent following a cumulative increase in interest rates of 3.50 per cent over 11 months.

The RBA says it took the decision to hold interest rates steady so it has more time to assess the impact of the increases in interest rates to date and the economic outlook.

That’s certainly good news for most borrowers, especially people with variable rate home loans.

Many of them have seen their monthly mortgage repayments creep up by between 30 and 50 per cent from what they were back in early 2022.

The average interest rate on a standard variable mortgage with a 70-80 per cent loan-to-valuation ratio is now around 5.50 per cent. Some mortgage products are charging customers over 6 per cent.

But there’s another large sub-set of home loan customers – around 1.33 million according to the RBA – that are clinging to the edge of what many have described as a fixed-rate mortgage cliff.

When interest rates were at record lows in 2021, many of them were able to secure two- to three-year fixed-rate loans at rates close to 2 per cent. Some two-year honeymoon rate deals were priced under 2 per cent.

In a research paper released last month entitled Fixed-rate Housing Loans: Monetary Policy Transmission and Financial Stability Risks, the RBA estimated that 880,000 fixed-rate home loans will expire and roll over to variable rate loans during this year. Another 450,000 will expire in 2024.

Large repayment increases ahead

A borrower with a $500,000 mortgage (over 25 years) currently locked in at a low fixed-rate loan of 2 per cent would see their monthly repayment jump from around $2,100 to $3,100 (assuming they move to a 5.5 per cent variable rate) once their fixed-rate loan expires.

A 0.25 per cent rate rise increases loan repayments by around $80 per month.

The RBA notes that while these monthly increases are large, most borrowers on fixed rates have benefited from a long period of paying low rates compared to borrowers on variable rates.

Yet, while that has definitely been the case, there are general concerns that some borrowers on low fixed-rate loans may struggle to afford a large increase in their repayment obligations.

“A key issue for the economic outlook, and by implication financial stability, relates to the ability of borrowers with fixed-rate loans to adjust to substantially higher borrowing costs when their fixed-rate mortgages expire,” the RBA says.

“While many borrowers on fixed rates may have saved or be saving in preparation for higher loan payments, some may have used the period of low fixed borrowing costs to consume more than they would have otherwise”.

The RBA says the “large and discrete increase” that the fixed-rate loan borrowers have faced or will soon face in their mortgage payments is one of the factors expected to contribute to slower household consumption in the period ahead.

Loan refinancings continue to surge

Borrowers on low fixed-rate loans may have little alternative but to refinance their outstanding loans to a higher variable rate when their fixed term expires.

Fixed-rate loans that roll over to a variable rate loan with the same lender don’t show up in official lending statistics. However, the Australian Bureau of Statistics (ABS) does keep a monthly record of home loans that borrowers refinance with another lender.

ABS lending indicators data released at the start of April shows that “external refinancing” of owner-occupied mortgages reached a record $13.62 billion in February 2023. This was up from $13.16 billion in external refinancings in January.

Over the six months to the end of February this year the value of external refinancings for owner-occupied loans was just under $78 billion.

Credit ratings agency Moody’s in March 2023 gave a “credit negative” review of the Australian residential mortgage-backed securities market.

Many of the mortgages in this segment are provided to higher-risk borrowers in the form of “low-doc” loans – meaning the relevant borrowers were able to secure loans without having to show extensive documentation to the lender demonstrating their ability to repay their outstanding debts.

However, some major Australian home loan lenders are reporting that at this stage mortgage defaults and home repossessions are occurring at a rate no higher than they were at the peak of the global financial crisis.

Our view on interest rates

Vanguard believes the RBA is now likely to keep rates on hold as it assesses the impact of all its rate rises on bringing inflation down. Our base case is that the RBA may then start cutting rates in mid-2024.

“We have pencilled in May 2024 as a rough date,” says Alexis Gray, Senior Economist, Vanguard Asia-Pacific. “We believe that the conditions for a rate cut will not be met until that time.

“Those conditions are that inflation has cooled, and is projected to fall back to target, or even lower. At the moment the economy is still resilient despite a significant increase in interest rates, and the labour market remains tight.

“As a result, inflation is uncomfortably high and monetary policy must remain restrictive to help guide inflation back to the RBA’s 2-3 per cent target.”

Vanguard, Smart Investing