Rising borrowing costs will likely see property prices fall, however, the magnitude and timing is unclear according to the Reserve Bank of Australia.
Speaking at the AFR Property Summit 2022, RBA Head of Domestic Markets, Jonathan Kearns said while higher interest rates will hit the hip pockets of homeowners, reduced borrowing capacity will have a more immediate impact on property values.
“A lot of media attention is placed on the increase in existing borrowers’ repayments when interest rates increase,” Mr Kearns said.
“But higher interest rates also reduce the maximum loan size for prospective borrowers looking to purchase housing.
“A lender works out the maximum loan size for a prospective borrower by ensuring that the sum of repayments on that loan and the borrower’s expenses do not exceed their income.”
Mr Kearns said lenders don’t use the current interest rate on that loan in that calculation but an interest rate at least 3 percentage points higher than the current rate.
“The increase in the cash rate since May has been 225 basis points, and so this has had a much larger impact on maximum loan size than APRA’s requirement,” he said.
“Given this 225 basis point increase in the cash rate has been fully passed through to mortgage interest rates, it will have reduced borrowers’ maximum loan size by around 20 per cent.
“And because the assessment rate also applies to any existing debt, the decrease in borrowing capacity is even larger for prospective borrowers who have existing debt, such as property investors.”
While higher interest rates will eventually cost homeowners more each month, in the short-term, many will be buffered by fixed-rate loan products, Mr Kearns said.
“Currently around 35 per cent of housing credit is fixed-rate debt, higher than the one-fifth that is more usual historically,” he said.
“These borrowers won’t face an increase in their interest expenses and loan payments until their fixed rate expires.
“And a large share of variable rate borrowers have been making excess mortgage payments into offset and redraw accounts.
“For many borrowers, these larger payments will mean that actual payments need not increase by the full amount of the change in required payments that result from the higher interest rate.”
Another factor that will help home buyers in a higher interest rate environment is the fact that most don’t max out their borrowing capacity, according to Mr Kearns.
“On borrowing capacity, most home buyers do not take out the maximum size loan that their bank will give them,” he said.
“In fact, in recent times, banks have reported that only around 10 per cent of borrowers take out a loan close to their maximum possible size.
“As a result, even if all borrowers’ maximum loan size is reduced by 20 per cent in response to higher interest rates, not all new borrowers will have to take out a loan that is 20 per cent smaller.
“For many borrowers, the amount they spend on a new home would decline only slightly or not at all.”
While falling prices might hurt homeowners in the short term, new home buyers will benefit in the long run as homes get more affordable, Mr Kearns said.
“Rising interest rates increase the cost of owning a home,” he said.
“This effect is more or less immediate – for borrowers on variable rate loans it likely occurs within one or maybe out to three months.
“Over time, however, the increase in interest rates works to reduce the demand for housing and so housing prices decline.
“This means that a household would need a smaller mortgage to purchase a first home or if they were upgrading.”
Mr Kearns said estimates suggested the net effect is that mortgage payments for new buyers would be higher for about two years as a result of higher interest rates.
“But after that, the declines in housing prices and mortgage size begin to dominate,” he said.
According to Mr Kearns, higher-priced homes are typically the ones most impacted by higher mortgage rates.
“This matches the observation that housing prices in more expensive locations are more cyclical.
“Similarly, there is some evidence that detached houses are more sensitive to changes in interest rates than apartments.
“It appears that the limited supply of available zoned land partly explains this result.
“Overall this indicates that an increase in interest rates narrows the distribution of housing wealth since more expensive properties experience a larger fall in prices.
“But their results suggest that this distributional effect is temporary as the effects of interest rates on more expensive and cheaper properties converge over time.”
Mr Kearns also said estimates suggested the fall in commercial property prices in response to higher interest rates appears to be slower, and slightly smaller in magnitude, than for residential property.
“An increase in interest rates that leads to a reduction in investors’ risk appetite typically tightens financial conditions,” he said.
“This results in a higher risk premium and so puts additional downward pressure on commercial property valuations.”
