Can homebuyers benefit from rate hikes?

The last few months of upswing in the cash rate could arguably be the most aggressive the Reserve Bank of Australia (RBA) has been but a remark from a central bank official provides insights as to whether these hikes could actually benefit homebuyers.

In a speech during the AFR Property Summit 2022, RBA head of domestic markets Jonathan Kearns shed light on how interest rates, which have been the hot topic since the central bank began its hikes in May, would affect property prices and borrowers.

“We know that higher interest rates will tend to depress residential property prices but there is considerable uncertainty about the magnitude and even the timing,” he said.

Mr Kearns said the impacts of interest rates on both property prices, borrowing power, and mortgage costs seemed to be connected in some way.

“This effect is more or less immediate — for borrowers on variable rate loans it likely occurs within one or maybe out to three months,” he said.

Still, while rising interest rates increase the cost of owning a home, it also reduces the demand for housing, which then slows down price gains.

“This means that a household would need a smaller mortgage to purchase a first home or if they were upgrading.”

For new buyers, the net effect of interest rate hikes is higher mortgage payment for new buyers for about two years.

After that, however, the ripple effect from the declines in house prices and the impact of rate hikes on borrowing capacity become more prominent.

“This exercise obviously abstracts from the many other factors influencing interest rates and housing prices, but it suggests that because higher interest rates reduce housing prices and so mortgage sizes, mortgage payments for new borrowers could ultimately be lower than if interest rates had not increased,” Mr Kearns said.

In a nutshell, the lower house prices can theoretically offset higher mortgage interest charges.

Rate hikes’ impact on loan sizes

An increase in interest rates is often associated with an increase in repayments, especially for existing borrowers.

However, Mr Kearns said higher interest rates also reduce the maximum loan size for would-be borrowers.

“Lenders don't use the current interest rate on that loan in that calculation but an interest rate at least three percentage points higher than the current rate,” he said.

For context, the Australian Prudential Regulation Authority (APRA) increased the minimum serviceability rate last year from 2.5 percentage points to 3. This reduces the maximum loan size by up to 5%.

Mr Kearns said the 225-basis point increase in the cash rate since May has had a much larger impact on maximum loan size than the increase in serviceability rate.

“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%,” he said.

“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.”

A change in mortgage rates has a greater impact on new borrowers than a change in serviceability assessment rate — not only does this affect borrowing size, but it also impacts actual payments. Mr Kearns said this will ultimately influence how much people would want to borrow.

Meanwhile, Mr Kearns said a large share of existing 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,” he said.

This is where it gets connected — higher interest rates, reduced borrowing capacity, the increase in loan repayments typically result in a decline in new housing borrowing.

“The timing and strength of the relationship between interest rates and housing borrowing can vary, not least because the factors driving interest rates, such as income growth, can also directly affect housing demand, but there is no doubt that interest rates are an important determinant of housing finance,” Mr Kearns said.

Still, Mr Kearns said there are other factors that influence housing prices like income growth and population, which means that the impact of rate rises would likely be offset by other factors.

“The impact of interest rates on housing prices importantly depends not only by how much they change, but for how long,” he said.

“If interest rates were assumed to be 200 basis points higher forever then this model suggests that housing prices would end up being around 30% lower than if interest rates had not changed.”

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