High Australian mortgage rates are holding down the property market

Cost of service for the purchase of land forced on the purchaser, rise in speculation of land due to distorted tax policies, geographic limitations imposed on urban properties, availability of government grants and inheritance, and immigration problems all affect the price of a property. The rarely discussed behavioral reaction to changes in the interest rates of mortgage is the prime focus of this article.  

Housing in Australia is a very important consideration and unlike choosing between two cars costing $20,000 and $30,000, the decision to buy a house depends on whether you can afford it and whether 25 percent of the salary can be paid for servicing the mortgage. Undoubtedly high rates of interest for servicing mortgages in the late 1980s, which had reached its peak at 17.0 percent in 1989, had brought down affordability.  

For example, a couple each earning $26,611 on an average, paying 25 percent of what they earned together, would have been able to repay $13,306 on a mortgage for 20 years. This amount could service only $74,880 worth of mortgage in 1989 and $129,000 in 2007. With the average wage of adults being $55,920 at present, the same couple buying a house now would be able to service a mortgage value of $273,000 at 8.05 percent interest by paying 25 percent of their salary or $27,960 per year. 

It means, at present they can afford to service a mortgage almost double of what they could have in 1989. Though the 20 percent increase in wages has made it possible to some extent, the existing low rates of interest are also responsible for this increase in mortgage value. Conventional wisdom that affordability increases with lower rates of interest is strengthened further by this analysis. 

The “25 percent payment of income” rule is based on your capability of being able to make payments on your mortgage. As it takes many years to pay off a mortgage, you should consider as a foresight the increase in earnings over that period to come to a rational conclusion about your total capability to pay off that mortgage over that period.

   

The prevalence of high inflation during 1980s ate into wages, increased prices and increased the nominal rates of interest on loans. A burden of 25 percent of income is imposed by a mortgage that stays constant for a period of 20 years. But the 8 percent increase in wages progressively reduces this burden to 23 percent after the first year, 21 percent after the second year, 20 percent after the third year and so forth. As a matter of fact, the variable interest rate for a mortgage payment taken by people in 1980 would have reduced while their wages would have increased over time. 

    

The initial heavy burden of mortgage repayment would force you to defer on many things like having children, replacing appliances, cars, and furniture and trying to extend credit card debt payments.  The present low annual inflation of 2.4 percent does not provide the same amount of relief automatically as it did earlier even if you have a secure income. Relief from the heavy repayments for mortgage loans may not come as quickly as it did thirty years ago. As the struggle is longer now and living on a single income is quite unthinkable at present.    

Economists will agree that the effect being discussed in this article is the effect of real-life interest rates and not the nominal interest rates which are normally mentioned by lending agencies and banks through advertisements. Real life interest rates depend on inflation that is given by the following mathematical formula:

Real rate = Nominal rate – the rate of inflation

If the nominal rate were 17 percent and the rate of inflation 8 percent in 1989, then the real life rate would have been approximately 9 percent. Presently the nominal rate is 8 percent and the rate of inflation is around 2 percent that makes the real life rate approximately 6 percent. This fall in mortgage interest rates is not the same that the politicians debate about and has no immediate chance of coming down further as it did after 1989. For example, the real life interest rate fell by 4 percent when inflation came down, and nominal interest rates decreased.

As the real life rates have been varying between ten and two percent for the last thirty years, it does not make a good political story and the people in the government like Peter Costello try to avoid talking about it as well as the representatives of the Labor party as they want to avoid any suggestion makes the economy any more complex.

It is certain that no one wants high inflation to ease the burden of mortgage payments for short term gains. Rather the 25 percent and sometimes 30 percent of income rules of repayment should be moderated to make immediate repayment more convenient. It will be convenient if the concepts of nominal and real life interest rates are taken up in literacy programs of financial institutions and schools. But many politicians and parties want you to consider only nominal interest rates while employers do not want the raises in your salary get discounted when considered in real life situations and the union leaders also want to take the credit for negotiating the raises in salary for their members.     

Studies made on economic behavior shows that the education by itself can provide only partial improvement in making decisions. Economists who are experts on behavior believe that people are myopic when making decisions about borrowing as the repayment burden is not given much importance. This type of myopia did not cause much trouble in the 1980s as an increase in wages reduced the burden of repayment on a fixed mortgage. But the present burden of mortgage repayment may remain with you for a longer time as the comparative increase in wages is lesser now.

With politicians shouting about low-interest rates and financial institutions and lenders highlighting their innovative rates of interest for mortgage repayments, it is very hard to change the pattern of consumer behavior. As a matter of fact, the interest rates in Australia are climbing very steeply and may become the highest compared to all other developed countries soon.  

Solutions in fiscal reform such as reverting back to the earlier regime of capital gains tax, abolishing the effect of "negative gear" and the effect of considering depreciation and interest twice on investments on housing, making the "Australian Prudential Regulatory Authority" to encompass non-banking lenders, may be more helpful to consumers. Prohibiting the practice of sales based on commissions where the agents or employees get paid a percentage of the loan amounts that they can sell may be another solution. As per Louise Sylvan, the "Australian Consumers' Association" CEO, this practice brings in corruption, inflation in the prices of property, over-committed borrowers, and finally instability in the financial markets.