Here's how RBA rate hikes would crush the budgets of Australian mortgage holders

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For the first time in many years, rate hikes from the Reserve Bank of Australia (RBA) are now seen as a very real prospect by financial markets, potentially arriving as early as the first half of 2018.

Should that eventuate, it would be the first time since late 2010 that official interest rates have been increased.

Given the increase in household debt seen since the start of the RBA’s easing cycle in late 2011, leaving it at 122% as a percentage of Australian GDP, it’s understandable why some people are concerned about what impact higher interest rates will bring, especially at a time of soaring energy bills and weak wage growth.

Will households be able to cope with higher mortgage rates, and as a consequence higher home loan repayments for those with variable rates?

No one really knows the answer.

However, what we do know is that given the increase in the average size of an Australian mortgage since the GFC, rising to $260,000 from $180,000 back in 2008, any rate hike from the RBA will have a larger impact on monthly repayments than previously.

Nothing demonstrates that better than the chart below from Su-Lin Ong and Robert Thompson, strategists at RBC Capital Markets.

Source: RBC Capital Markets

It shows the increase in the average monthly mortgage repayment for variable rate holders should interest rates rise by 1% from current levels.

While 1% doesn’t sound like much, taking the RBA cash rate back to just 2.5%, an increase of that magnitude would see the monthly repayment for an average sized mortgage rise sharply as a result.

“Given the increase in the size of the average loan, a 100 basis point hike now would take monthly repayments beyond 2011 highs seen after the RBA cash rate was lifted by 175 basis points to 4.75%,” says Ong and Thompson.

“Debt servicing would likely rise by a similar amount should wages growth remain relatively stagnant.”

This table from RBC shows the sensitivity of monthly home loan repayments to a move in interest rates of 25 basis points. The current level is highlighted by Ong and Thompson.

Source: RBC Capital Markets

Should interest rates increase by 1%, it would see the average monthly repayment rise from rise to $1,602 from $1,450 based on RBC’s modelling. That would equate to around $1,800 extra per year to service an average-sized mortgage.

To some that may not seem a lot, but to others it likely will, potentially creating further strain on already stretched household budgets and the outlook for household spending.

“It would add to the list of challenges for household consumption which continues to run below trend,” say Ong and Thompson, adding that an 1% increase would reduced household disposable income levels by around 0.6% of Australian GDP.

Based on Australia’s most recent GDP report, that would equate to a reduction in disposable income of around $10 billion.

At a time when household budgets are under pressure, Ong and Thompson say that underlines why any rate increases from the RBA, should they eventuate, will be slow and small in scale.

“The dominance of variable rate mortgage and larger average loan size suggests that RBA policy traction will be higher than previous tightening cycles,” the say.

“Reflecting a number of factors, any policy normalisation by the RBA is likely to be slow and cautious.”

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