In meeting with clients over recent months, one of the common questions I’ve been asked has concerned the potential “income shock” to be faced by households given the apparently large number of interest-only mortgage loans that may need to be reset into principal and interest loans over coming years. This note suggests that while this shock may well be a challenge for some households, overall this adjustment is not likely to pose major downside risks for the economy.
Almost a million households face a looming potential income shock
Media headlines try to be dramatic, and one of the most dramatic headlines in recent months has been the spectre of more than one million households facing a potentially steep increase in home loan repayments over coming years as their IO loan periods expire and their loans convert to principal and interest (P&I) loans.
There’s been a lot of numbers bandied about, and what follows is my own break-down of the relevant metrics that I think need to be considered – using data pieced together from Reserve Bank research*.
At face value, the numbers appear frightening and some concern is understandable. For starters, just over 30% of the $1.7 trillion outstanding home loans (investor plus owner occupier) are IO loans, and around two thirds of those – worth round $350 billion – are scheduled to be converted into P&I loans over the three years to end-2020. As seen in the chart below, this amounts to around $120 billion in loan conversions each year.
For the households concerned, the payment shock could be significant. Assistant RBA Governor Christopher Kent noted a “representative” household facing such a mortgage reset could have a loan of around $400,000 payable over 30 years. Assuming an interest rate of 5%, the annual repayments on an initial 5-year IO loan period would have been $20,000 per year. Annual payments on a P&I loan over the remaining 25 years – assuming the same interest rate – would jump to $28,000, or $26,000 if the remaining loan period were re-set at 30 years.
Either way, that’s a jump in payments of around 30 to 40%! With $120 billion re-set each year and assuming an average mortgage of $400,000, it implies around 300,000 households could face such an income shock – worth $2.1 billion in aggregate – each year for the next three years.
Hence the nasty headlines.
The nation-wide income shock should be contained
So far so bad, but how do these numbers compare against the aggregate size of the economy? It turns out the aggregate income shock could be at worst a flesh wound.
How so? For starters, it’s worth remembering we’ve got a $1,800 billion economy and around 10 million households. So it already implies only around 3% of households would be affected by these mortgage re-sets in any given year – and about one in ten over three years.
Total annual household disposable income is currently around $1,200 billion. So a total aggregate household income shock of $2.1 billion amounts to around 0.18% of household income each year. What’s more, about 60% of these re-sets would affect investors rather than home-owners – who in general have higher levels of income and wealth and might be better able to manage the higher repayments.
The RBA’s specific estimates are outlined in the chart below.
What’s more, the numbers above assume all mortgages subject to a reset will leave households with higher repayments. In reality, and even allowing for some tightening in credit standards, some households may still be able to negotiate a new interest-only loan (especially well-off investors) and others may be able to limit the hike in repayments by extending the term of the loan – especially if substantial home equity has been built up.
Many households have also built up mortgage buffers through early repayments, which the RBA estimates are worth almost 20% of the outstanding value of home loans. Indeed, around one half of households are at least six months ahead in their home loan repayments.
Note, moreover, that the process of re-setting loans has already begun, thanks to the regulatory clamp down in IO lending and increase in mortgage rates on such loans. Kent notes there was a reduction of $75 billion in IO loans over 2017. And while scheduled mortgage repayments did increase over the period, this was largely offset by a reduction in unscheduled payments (i.e. early repayments) so as to leave overall household mortgage repayments (as a share of disposable income) broadly unchanged.
According to Kent, “our liaison with the banks suggests that most borrowers have managed the  transition reasonably well. Also, the share of non-performing housing loans over the past year remains little changed at relatively low levels.”
As to what lay ahead, Kent concluded “the available data, and our liaison with the banks, suggest that there are only a small minority of borrowers who will need to reduce their expenditure to service their loans when their interest-only periods expire.”
No time for complacency
Of course, risks remain – especially as the cumulative impact of less favourable financing could mount over time. There are also multiplier effects to consider, as even a marginal slowing in spending will have second round effects through the economy. All that said, it’s still a stretch to believe the upcoming spate of mortgage resets necessarily imply a doomsday scenario for the economy.
As is the case more generally with the nationwide housing slowdown, while some “pockets” of housing pain are likely, the economy-wide effects should again prove relatively well contained.
*RBA Statement on Monetary Policy, May 2018 and “The Limits of Interest-Only Lending”, speech by RBA Assistant Governor Christopher Kent, April 2018.