What’s wrong with Australian mortgages? They are set for shareholders, not owners

If you’re paying off a mortgage — or aspiring to — imagine if you didn’t have to worry so much about rising interest rates.

This is already the reality for American buyers. Unlike Australia, most mortgages in the United States have a fixed interest rate, locked in for 30 years.

Instead of having to wait and see if their central bank (the Federal Reserve) raises rates every month, a US 30-year fixed mortgage at 2% will still have the same monthly repayment, even after a rate hike.

On the other hand, when the Reserve Bank of Australia raises rates, it has huge implications for household budgets, as most borrowers still have variable rate mortgages.

The challenge for Philip Lowe is to use his interest rate firepower Goldilocks style.(ABC News: Matt Roberts)

Every time the cash rate goes up, and the banks inevitably experience that increase, our mortgage payments go up too, adding thousands of dollars to the average annual repayments.

This is one of the reasons why RBA Governor Philip Lowe has been so cautious about the strong signal from the US Federal Reserve to raise interest rates.

So why aren’t Australian lenders also offering 30-year fixed rate mortgages like their US counterparts?

Every extra 1% can cost thousands

Here in Australia, an extra 1% on a $600,000 mortgage means an extra $6,000 a year in interest payments. And those are after-tax dollars. So, if you earn $100,000 and therefore pay an average tax rate of 25%, that equates to a pay cut of about $8,000. Ouch.

A 3 per cent rise in official rates over two to three years is not impossible. On a $600,000 mortgage, that would mean an extra $18,000 a year in interest payments.

The RBA knows that, of course. He looks at Australian household debt at over 120% of GDP and knows that raising rates too aggressively risks putting a significant number of Australian households in financial difficulty.

In a way, this is good news. This means that the RBA has ammunition to fire in pursuit of its monetary policy objectives (to keep unemployment low and inflation between 2% and 3%).

But it would be better if the Australian mortgage market carried less risk for consumers.

There’s no reason Australian lenders can’t offer 30-year fixed rate mortgages. After all, there is an active government bond market with maturities ranging from one year to 30 years. This provides a benchmark for mortgage pricing.

Two solutions for more affordable mortgages

Fixed rate mortgages have become much more popular in Australia in recent years: the proportion of new fixed rate mortgages has increased from around 15% in June 2019 to over 45% in September 2021.

A gray and red column chart shows the proportion of fixed rate home loans of all home loans in Australia

But even these loans are usually only fixed for three years – sometimes as short as one year, sometimes as long as five years. After that, the rate reverts to variable rate.

Longer fixed rate loans would protect Australian borrowers from large interest rate swings. In the United States, you can refinance a 30-year fixed mortgage if long-term rates drop. So you benefit if rates go down, but you are protected if they go up.

Another idea to improve the terms of loan contracts for borrowers – long advocated by University of Melbourne economist Kevin Davis – is the so-called ‘trailer mortgage’. These contracts limit borrowers to pay a certain “spread” over a benchmark interest rate.

These offers largely depend on competition in the banking sector. The United States has a lot of competition in the banking sector. Australia has very few.

When costs rise, two groups can bear that cost: customers or shareholders.

In Australia, when bank funding costs rise, customers bear almost all the costs and shareholders zero. This is the best proof that you will ever have real market power.

A mini house keychain and a set of keys on a wooden table
Longer fixed rate loans would protect Australian borrowers from large interest rate swings.(Unsplash: Land of Mallorca)

Thread the needle

The Reserve Bank is well positioned to bring the official unemployment rate down from 4.2% to 50-year lows while keeping inflation under control. He knows that when he raises interest rates it has a very direct impact on the real economy.

The challenge for Lowe is to use its interest rate firepower like a goldilocks: not too little, but not too much. This will be the big challenge for central banks in the coming years.

If we could restructure the Australian mortgage market to better protect borrowers against interest rate fluctuations, the job of future RBA governors would not involve such a delicate balancing act.

Richard Holden is Professor of Economics at UNSW. This piece first appeared on The Conversation.

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