What happens to the economy if you can’t pay off your home loan?

Australia is seeing mortgage stress and other cost-of-living pressures rise, but we can avoid the financial impact being felt in the UK and US, says property expert from the UNSW Business School.

For economists – and indeed anyone else interested in how much they spend at the supermarket – the cost of living and housing prices have been hot topics in 2022. The Reserve Bank of Australia (RBA) has tried fight rising inflation with interest rate hikes (read how it works here).

The latest hike was announced by the RBA last week, on November 1, with the official exchange rate rising to 2.85%.

“Australians have been fortunate to see sustained house price growth for some time now,” says economist and property market expert Dr Kristle Romero Cortés, associate professor at Australia’s School of Banking & Finance. ‘UNSW Business School. “But they need to know that house prices can also go down.”

“The comments on the housing market are quite sensational in the media.”

But when it comes to not being able to pay the mortgage and the impact higher loan repayments could have on the economy? It’s a little more complicated to predict.

Why Australia can’t follow other countries in financial disaster

Australians need only look to the UK to feel nervous as they witness the impact of inflation and high interest rates on the economy and daily life of the situation finances of its citizens.

Like Australia, the UK’s central bank (the Bank of England) introduced a series of interest rate hikes that had limited effect. Unlike Australia, the UK economy is still reeling from Brexit, plus a post-pandemic recovery, high inflation and energy costs, and levels of wage stagnation that have seen various sections of the working population do strike.

The country has also just suffered the effects of a disastrous set of economic policies and sweeping tax cuts for the wealthy implemented by Liz Truss as Prime Minister, which would have put money into an economy already inflated (where the idea is usually to ‘cool’ things down by encouraging people not to spend).

It scared the financial markets so much that investors quickly sold British assets, including government bonds. The value of the pound plunged, forced the Bank of England to take an unprecedented step and pledge £65 billion in bonds to prevent pension funds from failing and stabilize the market…and pushed Liz Truss to resign after only 44 days.

For the average Brit, this has led to a greater threat of recession: something that could lead to job losses, rising unemployment, rising inequality, wage growth too low to match price increases and cost coverage issues, such as mortgage payments that have already increased due to rising interest rates.

But does the situation in the UK foreshadow a DRAMA for Australia’s economy and housing market? Dr. Romero Cortés says no – for several reasons.

Australians are fans of variable rate loans – unlike the UK

As well as not experiencing a Brexit-style crash or energy price crisis to the same degree, a big difference is that Australians are more likely to have opted for the more flexible variable rate mortgages than in the UK. UK, where homeowners are more likely to have chosen a fixed rate mortgage.

In the UK, 74% of homeowners have a fixed rate mortgage for their home loans, and 96% have chosen this option since 2019, according to data from the UK-based trade association, UK finances. Data from AMP Capital shows that Australia has a higher share of mortgage holders with variable rate mortgages. Only 10-15% chose fixed rates before 2020 (although this figure rose to 40% in 2020-2021).

While variable rate mortgages can be a great option when interest rates are low in the short term, fixed rate mortgages can be more predictable in the long term as they are less affected by rate hikes. interest that can increase overall home loan repayments.

“What we see in the United States or Europe is not necessarily what we will see here,” says Dr. Romero Cortés. “The US Federal Reserve (Fed) or the Bank of England are also trying to effectively slow the economy, but when they raise their rates they can’t reach a large portion of homeowners who have a fixed rate mortgage of 30 years.

“The Fed and the Bank of England can raise cash rates as much as they want – they’re not getting to those homeowners.

“In Australia, our RBA increases go through banks almost instantly to consumers,” she explains. “There is a slight delay because the banks want to give borrowers as much time as possible to budget for an increase, but that rate almost automatically passes in a much faster way here than you will see in countries like the States United States and the United Kingdom.”

This means possible faster cooling impacts on the economy with the RBA setting up interest rate hikes.

Another important factor is that Australia’s big four banks are heavily capitalized.

“They are full of money,” says Dr. Romero Cortés. “I study the financial network in Australia, and it is very strong. We won’t see the kind of crisis we saw in the United States in 2008, where banks were holding assets whose underlying value they didn’t understand.

What does this mean for mortgage stress and the Australian economy?

Dr Romero Cortés said that while raising interest rates could mean Australia will see mortgage stress rise faster than elsewhere, it is this situation that is helping the RBA prevent the economy from “turning red” and collapse on itself.

“Like any central bank, the RBA wants to ensure price stability, and they will do everything in their power to prevent us from losing it. They don’t want consumables like bread and eggs to suddenly be seven times higher. dear the next day. If that happens, people will revolt, indeed.

“We are far from here. But that’s why we don’t want to go near it. So the RBA stays very aware of this, and their role is to keep this issue front and center for the Australian public for as long as they need, so that they are more careful with their spending over a longer period of time. . ”

This is how the RBA plays a role of psychological and not only financial stabilizer.

“You know, ‘Okay, the RBA is on this: so I don’t need to panic,'” says Dr. Romero Cortés. “Because if you, as a member of the financial public, start to panic, you’re more likely to make poor financial decisions that have more of a domino effect on the wider economy.”

That said, there is a limit to the financial stress homeowners can experience.

“There could be a point where owners and others can no longer afford the increased monthly repayments,” she says. ” It’s not yet the case.

“Long term, you expect some kind of horizon where things stabilize around 4 or 5% cash rate. Australia is highly leveraged (meaning it has a high level of debt to equity on average), so more than that would be hard to sustain.

Banks don’t want to see mortgage defaults

Ultimately, lenders don’t want homeowners to default on their loans or to repossess. It costs them dearly, in time, effort and capital, says Dr. Romero Cortés. They much prefer to work with the borrower before they get to that point of extreme financial hardship.

“A financially distressed homeowner would contact your bank, who would require financial hardship documentation, and then work with you on a payment plan or plan for deferral, refinancing, or interest-only payments. “

Remember: you will not get out of it. You’re still paying it, the interest is still accruing, and it could extend the term of the loan. All this means that borrowers will consume less in other places, and is therefore supposed to lead to a “cooling” of the economy.

What happens if the cost of living does not drop?

But if living here becomes too difficult and too expensive with inflation or higher mortgage repayments, you could see Australia’s reputation as “a good place to live” take a hit, driving down the number of people who want to live here and putting additional pressure on an already tight job market, says Dr. Romero Cortés.

For example, a portion of all Australians of foreign origin might decide that Australia is too difficult and too expensive to live in and move to their other country of citizenship. That’s when it might start to get uncomfortable.

“Australia has an economy that has been built on people wanting to come to Australia, and we are constantly growing that way,” says Dr Romero Cortés. “There is a demand for housing, education, and we currently have people ready to come here.

“So the government can say what they want about the RBA [and their decision to raise rates] to be elected again. But the RBA has no choice: a family defaulting on their mortgage, when not everyone can afford to buy bread, that’s what it envisions.

Does all this mean that real estate prices will fall further?

Higher mortgage repayments could induce owners to accept lower selling prices than they might have expected for their property, investment or otherwise; driving down overall prices in the real estate market over a period of time, as well as the occasional “fire sale”.

“But we might see a little price depression where 5-10% of the price is cut. Even if you take 10% off a $2 million house, that’s $200,000 less. That means, at Unless they have to, sellers won’t want to sell.

All of this means it’s true that you’re going to see sky-high mortgage payments and additional cost-of-living pressures as homeowners prioritize their mortgage repayments, Dr. Romero Cortés points out.

Dr. Kristle Romero Cortés is an Associate Professor in the School of Banking & Finance at UNSW Sydney Business School, an expert in real estate economics and previously worked at the Federal Reserve Bank of Cleveland.