How will the "mortgage cliff" potentially impact property prices?

Despite the fact that the RBA kept rates on hold this month, there is still a huge portion of borrowers who are about to face an unprecedented increase in their mortgage repayments.

Borrowers who are on fixed-rate loans have likely been spared much of the pain that has been thrust upon borrowers with variable rates, but this is rapidly about to change. The interest rate reset that these borrowers are about to be hit with is known as the mortgage cliff, and it could impact more than 1 million households.

Historically in Australia, less than 20 per cent of all loans have been fixed. Most borrowers typically go with a variable loan which changes when the RBA adjusts the official cash rate. For the most part, this has worked well for homeowners, as interest rates have been trending lower for the past 30 years.

However, when COVID hit, this dramatically changed the direction of interest rates. One of the first things the RBA did was to slash the cash rate to 0.1 per cent. What this meant was that mortgage rates ended up being around 2 per cent.

For a borrower, that meant you could get a $1 million loan and only be required to pay $400 per week in interest. This was an unprecedented and arguably unsustainable level, and it was the key driver of the subsequent house price boom that played out over the next few years.

But what also happened during that period was a big jump in the number of fixed-rate loans. The RBA lent $188 billion of three-year fixed-rate loans to the banking system at an annual cost of between 0.1 and 0.25 per cent during the pandemic.

This meant a borrower could take on a two or three-year fixed-rate loan at around 2 per cent in that 2020/2021 period and lock in their interest rate. Many borrowers took up this offer, and that saw the share of fixed-rate mortgages surge to almost 40 per cent of the stock.

Philip Lowe also famously said interest rates wouldn't be rising until 2024. This spurred borrowers to rush out and borrow and capitalise on the boom in property prices.

Then something changed. COVID fear went away. Government lockdowns ended. But inflation started rising. This was to be expected after the huge spending spree from Governments and the record low-interest rates propping up the economy. When inflation started moving higher and staying high, the RBA and other central banks around the world needed to act.

Now that we've seen rates rise sharply, it also means that the time is coming when fixed-rate borrowers will need to increase their repayments.

To put that in context, if the same person who borrowed $1 million at just 2 per cent now sees their interest rate increase to 6 per cent, that means instead of paying $400 per week in interest, that surges to $1200 per week.

For many households, that is going to put them under severe mortgage stress.

Borrowers trapped

One of the first issues that borrowers face is that they are also unlikely to be able to refinance all that easily. When you refinance, you need to be able to qualify for a new loan. If rates are higher and your income hasn't changed, then you can't easily apply for a new loan.

The other factor to consider is the impact of serviceability buffers. These are buffers that borrowers need to be able to meet above-normal interest rate levels when they apply for a new home loan.

Typically, if the current interest rate is say 5 per cent, for example, when they apply they might need to be able to service a loan with a 8 per cent interest rate. This protects the lender in the event rates do rise.

Theoretically, these serviceability buffers should protect some of the borrowers who applied for very cheap loans. However, the flip side of that is that being able to refinance to cheaper rates becomes challenging.

Impact on property prices

The main impact of the mortgage cliff is most likely that it is further in-built monetary tightening. That means that even if the RBA has finished its hiking cycle, there is still a huge portion of borrowers who are going to be impacted in the months ahead. This will likely weigh on demand for property and mean the current bounce in property prices will be facing some headwinds.

In terms of borrowers getting into financial trouble and not making their repayments, the impact is going to be felt most of all by those most recent borrowers who are on lower incomes. This is normally your mortgage belt suburbs that feature a large proportion of first-home buyers who are highly leveraged. With many that will have a very high 90 per cent plus LVRs. This is common in the outer suburbs of any city where first-home buyers often buy.

On the flip side, it's also important to remember that not all homeowners have a mortgage. In fact, over 30 per cent of households don't have a mortgage. Baby boomers for example most likely don’t have a mortgage and they are now getting high interest on their savings.

Also, if you purchased your home many years ago, you're also likely sitting on a healthy equity increase and had the benefit of getting ahead during the COVID years when interest rates were low and you had no way to spend your money.

When looking at the impact of the mortgage cliff, it doesn't mean that property prices are going to plummet. There will certainly be a segment of the market that is impacted, but we also have to remember that with record immigration and the already low level of stock, there is still a lot of demand in the current market and many homeowners who are in very strong financial positions.