12 Jul 2023

How the Fixed Rate Cliff will hurt

In Part 1 of this series, we have looked at how the fixed rate cliff came about which was due to a combination of the following:

  1. Stimulatory monetary policy dating back to the GFC;
  1. Record low interest rates in response to the Covid-19 pandemic; and
  1. The abundance of liquidity provided by the Reserve Bank’s (“RBA’s”) Term Funding Facility.

Now that we are at the precipice, what does that mean for the Australia households and the economy at large? So in this Part 2, we continue our discussion on the Fixed Rate Cliff.

Impact of the fixed rate cliff

At the household level, the pain of the Fixed Rate Cliff will be felt directly in a significant cash flow crunch.  

Many households will face a sizeable “step-up” in mortgage repayments as 12 months or more of rate increases are felt all at once.  

As an example, households with a $1M P&I owner occupied mortgage and fixed for 2 years at say 1.94% in March 2021, would have seen their repayments rise from $4,209 to $6,064 – an increase of over 40%.

At the macro level, the jury is still out on the degree of impact to the economy, as well as house prices. 

Expected shock to household spending

On one hand, a material economic slowdown is expected, and there is likely to be some system shock to household spending.  

Analysis by Bloomberg Intelligence, suggests: the “fixed-rate cliff” could reduce retail sales by $9B or 2.2% of 2022 calendar year sales – however, Bloomberg believe this is not enough to cause a recession. 

At the same time – KPMG estimates the impact to overall household consumption to be circa $20B lower over 2023 as a direct consequence of monetary policy tightening, with 1% being shaved off GDP.

Supporting these theories of a low a slower economy are the fact that there are characteristics of fixed rate loans which make them riskier than their variable counterparts.  

Indeed, the RBA has found that Fixed Rate loans: 

  1. Have higher balances relative to borrower incomes i.e. higher Debt to Income ratios (DTI’s > 6); 
  1. Have Higher Loan to Value Ratios (LVR’s > 80%); 
  1. And tended to be newer loans – and thus by their very nature, have had less time to accumulate equity or liquidity buffers. 

This has lead to the speculation that many Fixed Rate borrowers are becoming “Mortgage Prisoners” – that is, a cohort of loan customers who are trapped with their existing lender because they cannot meet the serviceability standards required in the current market to refinance. 

Indeed, many Fixed Rate borrowers took out their loans at a time when the assessment rate by applied by their bank were in the realm of 5.5-6%. 

An assessment rate is intended to be the interest rate that the bank tests you on to decide if you are eligible for a loan, not the rate they expect you to actually pay. A 3% buffer is typically applied to your actual interest rate to derive the assessment rate.  

However, this 3% buffer was breached in December 2022, after 8 months of consecutive rate rises since May 2022, leading many in the finance community to believe a large chunk of Fixed Rate mortgage holders will be unable to refinance.  

Some economists believe the impact to economy will be minimal

On the other hand, some economists believe the impact of the Fixed Rate Cliff to the economy will be minimal. 

There has been significant research conducted by the RBA around the resilience of the housing market, and in particular household savings buffers.  

While fixed rate loans, are more risky, the difference in risks compared to variable loans are not large. This is because: 

  1. Many Fixed Rate borrowers made significant pre-payments prior to their loans being fixed 
  1. Many Fixed Rate loans have also have a variable split, where the bulk of savings are held, and these amounts are similar to 100% variable-rate holders 
  1. Finally, many Fixed Rate holders hold their savings in non-mortgage based products. That is, their savings are held elsewhere outside of offset accounts and redraw facilities, and there is evidence that shows then fixed rates expire this money is returned immediately to pay down or offset previously fixed home loans.  

As a practical matter, many Fixed Rate borrowers have also had much time to prepare for the expiry of their fixed rate loans.  

Many have benefited significantly from having a lower repayment, which has allowed them to accumulate savings buffers. However, the RBA notes that it is not easy to measure whether these buffers have indeed been saved, or have been spent over the fixed rate period for households in aggregate.  

The RBA also argues that the mortgage market is fiercely competitive, allowing fixed rate customers to achieve better rates, and with some banks offering cash rebates. 

Again, this depends on a borrower’s ability to refinance, rather than being a “Mortgage Prisoner”.  

Estimates suggest around 16% of existing loans are unable to meet serviceability assessments conducted at current interest rates. If mortgage rates were to increase by a further 1 percentage point, the share of loans unable to refinance with another lender is estimated to increase to around 20 per cent. Newer borrowers are over-represented in this cohort, especially the small share who borrowed close to their maximum capacity when interest rates were very low.

On this, the RBA notes that even for Mortgage Prisoners, at least one-third of Fixed Rate Holders have been able to negotiate with their lenders to achieve a better variable rate, than if they had done nothing. 

Our view on the fixed rate cliff’s impact

So what does this look like on the balance? While the net effect of the Fixed Rate Cliff will have a negative impact on the economy and house prices, it will not by itself be a driver of financial instability. 

There are three data points or pieces of analysis in support of this argument.  

  1. Despite rising interest rates, home loan defaults are still extremely low. Although there is evidence that banks such as Westpac are starting to field more hardship calls.
  1. The percentage of “high LVR” households is currently not a source of concern. The percentage of households 
  1. Again, households in aggregate, have large savings buffers and household balance sheets remain “Strong”.

The combination of these factors means that there is unlikely to be a massive sell-off in the property market caused by the Fixed Rate Cliff alone. 

What does this all mean?

So what are the implications of this to households and the economy? 

This is happening to every household, and every lender – you are not alone. However, it does mean that there is “nowhere to hide” and the period of historically cheap money is well behind us.  

Looking ahead, is set to be a season of uncertainty and discomfort, especially for lower income households, first home buyers, and homeowners who purchased at the top of the market in the middle of the mid-pandemic liquidity boom.  

To navigate this time ahead you have to be proactive, and move the levers within you control to boost cashflow and create savings buffers, by either 

  • Increasing income; or  
  • Lowering expenditures 

There may also be buying opportunities for savvy investors, or households who have been waiting on the side-lines watching interest rates go up. So it is more important than ever to watch the economic data and understand the movements of the RBA and subsequently Australian Banks. 

We’ll unpack more on this topic in Part 3 when we discuss what you can about reducing the impact of the fixed rate cliff. Thanks for reading!

You can also watch the full version of the Mortgage Cliff Explained on Youtube.

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If you have any questions or comments on this topic, you are more than welcome to get in touch with me ().