Ensuring Long-Term Mortgage Affordability Via Optionality & Liability Management

Our widely quoted statistic is that 85% of Australian home loans are variable rate, with just 15% having any sort of fixed rate (mostly 2 & 3 years) and virtually no product offering beyond 5 year fixed. This is in huge contrast to the US and UK Mortgage markets, where 90% and 78% are fixed respectively. 90% of the US mortgage market is fixed for 15 or 30 years.

Market structure, including the regulations that govern banking, insurance and retirement systems are influencing factors in the US and UK. In Australia’s case, the dominance of a variable rate product allows banks to maintain strong pricing mechanisms over their home loan portfolios, which in effect ensures a strong level of profitability and stable banking system from their perspective.

However, this isn’t necessarily the best result for customers or the most profitable option for banks. More importantly, borrowers are left without the flexibility or certainty to manage their financial liabilities and exposure to interest rate risk – services banks should be offering. These products need to exist and our primary research suggests 25% of the entire mortgage market will move to these products within 3 years of launch.

Is Variable any different to short-term borrowing?

Borrowing short-term comes in various forms but having an interest rate that floats and can re-price is a risky consideration for the borrower. Consider this: if interest rates increase by 1%, how exposed would a variable rate borrower be? For a $500k loan that is an extra $5k per annum in payments, which is absorbing an extra 10% from the median gross household income ($80k) once you consider tax.

This is one reason why banks are required to measure serviceability on loans with a 2 or 3% increase in the variable rate. But do borrowers really pay attention to this and does the wider financial system understand what risk this will lead to? Can better customer solutions be developed?

We should assume 1% increase over the next decade will happen:

Nobody truly knows where interest rates will go but forward rates and the yield curve can give an indication. Extrapolating this, we can expect a cash rate of 2% within 7 years and 2.5% within 10-years.

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For borrowers, we might see lower rates but how much lower can they go? They certainly will never go zero. In terms of how high they can go, increases of 0.25% per annum wouldn’t be unheard of. At this rate, by year 7, a variable home loan rate could be as high as 5.25% – a rate seen less than 3 years ago.

I have mapped out the various future home loan interest rate paths on the chart.

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All borrowers will also have an unaffordable line – the extent to which they can no longer service their debt. I have put this at 1% above variable rates to show that what is affordable today may not be affordable by year 2023, leading to a spike in defaults to the segments that become overexposed (the RBA would have to allocate pain to somebody if they need to raise rates).

Fixing at 4.49% now for 10-years with the option to leave anytime:

Consider this option – fixing for 10 years but with the ability to leave anytime.

As a borrower, you take out the risk of higher rates straight away. You also can bring in the ability to take advantage if a rate drop occurs: optionality gives a borrower the basis for fixing at a rate they can definitely currently afford and plan towards but the option to take advantage if rates do decline.

This optionality then reduces the variability borrowers face: they will have a maximum of 4.49% interest rate but may be able to fix it to an even lower amount (I assume 3.50% appears n 2019). Further, if the affordability line moves upwards, they can take higher risk and return to a variable rate with full confidence they are no longer the segment that would feel the RBA pain if interest rates need to rapidly increase.

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This is a potential optimal answer and a financial product driven solution for borrowers. Even though it looks complex, the borrower use is simple: fix a rate but maintain the flexibility to move to a lower rate as it becomes available. No wonder why these types of products are popular overseas.

The US financial system has figured this out. Now is the time for the Australian financial system to figure it out too.

 

 

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