The rate trap Australians with houses are about to fall into
HAVE you ever been caught in an incoming tide?
One minute you're blissfully staring into some rock pools, admiring the miraculous diversity of aquatic life. The next minute, swirling water is rising round your ankles and you realise getting back to the beach will be difficult indeed.
The first wave of an incoming tide normally doesn't look like much. And last week's interest rate rise from Westpac looks like a tiddler. They lifted rates by .03 per cent per year for owner-occupiers. It adds $90 to the interest payment a $300,000 mortgage over the year. Stuff all really.
NAB's rate rise was a little bigger - they lifted rates for owner occupiers by .08 per cent. (Rate rises for investors with interest-only loans were much higher, but more on that later.)
Just yesterday ANZ followed suit, raising interest rates for investers by 0.25 per cent and the Commonwealth Bank followed shortly after, increasing rates for owner-occupiers by three basis points to 5.25 per cent per annum and increasingly investor loans by 24 basis points to 5.80 per cent.
Other banks are expected to follow.
We should pay very close attention. The tide of interest rates is turning and if we're not careful, a lot of Aussies could find themselves out at sea, out of their depth, gasping for air.
THE EBB IS OVER
Tides are caused by gravity as the moon draws the ocean to and fro. Interest rates are also caused by a kind of gravity: Low growth pulls interest rates down and high growth pulls them back up.
It is the slow grind of the global economy back into growth mode that is moving interest rates. America has had several years of strong growth now and its central bank has raised official interest rates twice. Europe is also past the worst. Around the world, rates are responding.
Australia's official interest rates are at the lowest point in history and most people think they won't fall any further.
The RBA will not raise official interest rates in the next few months, either. But of course the official interest rate is only one ingredient in the recipe that determines the cost of a loan, so we can get rising rates before the RBA moves a muscle.
BANK ON IT
Banks make money on the difference between the cost of getting money to lend (mostly via deposits) and the revenue from interest on lending. If the cost of paying interest on deposits goes up, they may raise lending interest rates even when the RBA is motionless.
And the RBA has found that in 2016, major banks started paying more for deposits. One reason the cost of deposits is going up is actually related to the reason the US is lifting rates.
Growth is coming back, slowly, and people are getting less nervous. Our obsession with saving is coming to an end. So banks need to pay more and more for deposits.
When economic growth comes back, it makes sense to invest in businesses instead of just socking money away. In the last few months, stock markets have shot up as people have done just that.
The S&P 500 has hit a record high, and so has the Dow Jones Industrial Average.
To invest in shares, investors have to sell other assets. One thing they've been selling off is bonds. The price of bonds has fallen very sharply in recent months, as this next graph shows.
(You're right: the line is going up not down! That's because bonds are graphed by looking at yield, not price. Yield is the difference between the price of a bond and what it pays to its owner. Rising yields mean people are selling the heck out of bonds and their prices are falling.)
"I OWN FIFTEEN HOUSES, THANKS TO THIS ONE WEIRD TRICK!"
One part of the Australian economy has been very cautious about the rising tide of interest rates. Business didn't borrow a lot in the bad times. But households did. It is likely to be households that get caught when the tide comes in.
Household debt is through the roof, although interest payments on that debt are currently very manageable.
As rates rise, interest payments will force households to change things up. One of the first things they might do is sell their investment properties.
Many houses are owned by investors. And saying they are "owned" is something of an exaggeration. More than 50 per cent of investor loans are interest only. That means the owner never actually pays off the house. The investors hold a mortgage and the bank owns the place, while they just pay the interest cost. (it's a great way to get the maximum return from negative gearing).
That kind of investment only makes sense when the price of the house is rising. If you get rising interest rates and falling property prices at the same time, housing investors with interest only loans will start to sell their houses so fast you can barely blink. That, of course, would accelerate any property price fall.
Banks may be trying to head this problem off. According to a Westpac spokesperson, the bank is encouraging customers making interest-only repayments to move to a principal and interest loan with a lower interest rate. "We believe that while interest rates remain low it is a good time for homeowners to reduce their mortgage," the spokesperson said.
Of course, a bank cranking up your interest rate and trying to make you own more of the asset might just make some investors nervous enough to sell.
Everyone who lives in Australia needs to keep an eye on the tides.