In this article I’m focusing on the idea of debt-to-income ratios. It is likely that they will be a key tool used by the Reserve Bank to meet its new house price stability objective.
The Government recently asked the Reserve Bank to include house price stability in its financial stability policy decisions.
In a way, the Reserve Bank was already doing this as reflected by the 40% LVR restriction on property investors that is now back in force (as of March this year). The subtle change in policy direction gives housing official recognition with the Reserve Bank’s objectives as opposed to a tenuous link to financial stability that the Reserve Bank had been relying on.
Some experts in the industry have interpreted this as the Reserve Bank will need to take into account house price stability in its interest rate decisions. I don’t think this is the case, but I do think we will see a wider macro-prudential toolset used. My view is that we are now going to see debt-to-income ratios used alongside LVR restrictions to limit house price growth.
Debt-to-income ratios will provide an absolute limit to how much homeowners can borrow, which will ultimately have an impact on house prices.
In a tight housing market, borrowers are bidding up to their maximum borrowing power. At any given auction, the person with the biggest combined deposit and borrowing power wins and the concept of ‘value’ has morphed into ‘whatever it takes‘. The internal dialogue in a rising market is that it doesn’t matter how much they pay, because in the future the house will be worth more.
But arguably we already have debt-to-income restrictions.
Banks already take into consideration debt-to-income ratios with borrowers. They use a test mortgage rate of between 5.50% and 6.50% to calculate mortgage payments and then assess a borrower’s ability to afford that based on their income. For low deposit first home buyers, bank calculations are tougher still, because they require a higher servicing surplus and won’t allow for other forms of income like boarder income.
If for example the Reserve Bank put a directive out that borrowers could not take on debt that’s more than five times their income, it would reduce current borrowing power which would forcibly have an impact that would flow through to housing. The challenge is the unintended consequences of a broad-brush policy. For example, how would it apply to business owners trying to borrow against their home to invest in their business?
Longer-term wholesale interest rates have increased by over 0.50% based on sentiment that inflation is on the horizon and increasing commodity prices. With unemployment at a low level, it would seem that the potential for further rate decreases has vanished. Rates are at their bottom and the next rate move is likely up.
But that doesn’t mean you need to rush out and fix long-term. It is important to stay focused on value-for-money. Years ago, I did an analysis of interest rate strategies over a couple of interest rate cycles and it showed that over time, the best performing strategy (in terms of lowest interest cost) was to fix for 1 year.
When rates do start to increase, they won’t go up much. A change in mortgage rates from 2.50% to 3.50% is an almost 50% increase in payments for an investor on interest-only, and a 12% increase in cost for a first home buyer. It won’t take much of an increase in rates to slow our market down and stamp out any inflation pressure.