The Shock of rising home loan rates

Interest rates are rising and that’s not good news for mortgage holders and first home buyers.

The biggest shock will be to the homeowners who first bought between 2014 and mid-2021. They’ve been paying historically low interest rates and never experienced a rate rise. It’s human nature to be shocked when something comfortable changes.

Mortgage interest rates have risen on average by 1.5% over the past three months. That’s unlikely to be the end of mortgage rate hikes.

A homeowner paying 2% interest on a typical mortgage at the beginning of 2021 could be paying 3.5% now, and 4% to 5% by the end of 2022. A 2% rise on a $500,000 mortgage is $10,000 a year. That’s a lot of extra cash to conjure out of your budget.

Mortgages could become unsustainable for some. With rising house prices many households have stretched to borrowing almost to seven to eight times their income just to buy a home. That doesn’t leave much spare income to save for rainy days or retirement.

More to come

The Reserve Bank of New Zealand, which sets interest rates is expected to keep raising the official cash rate (OCR). It has been raising rates to help cool the housing market and keep the economy healthy. The OCR is the rate that banks borrow at. They pass on rises to customers.

If homeowners are lucky mortgage rates will peak around the 4% mark for one year and 5% for two. Some economists are predicting they could go half a per cent higher than that.

What happens will be dictated by how well New Zealand comes out of lockdown. If house prices keep rising the Reserve Bank will most likely raise interest rates further, and/or bring in compulsory debt to income ratios (DTIs). That limits how many times salary a household can borrow. Even if the Reserve Bank doesn’t do that the ASB and BNZ have already imposed limits on debt to income for their customers. Other banks may take the same approach directly, or indirectly by changing their affordability calculations, even if the Reserve Bank doesn’t force it upon them.

Double whammy

Rising mortgage rates combined with soaring house prices are a double whammy for first home buyers. House prices have climbed by 50% over the past five years. When interest rates were low, the size of the mortgage wasn’t as much of a concern because fortnightly or monthly repayments were reasonably affordable.

The double whammy is one of the reasons the Reserve Bank is so concerned about stabilising house prices. If mortgage rates are 2% higher, borrowers might think twice about buying a home, lessening demand. Home buyers don’t then borrow beyond their capacity, which is good for economic stability.

Banks test rates

When actual interest rates rise, so too do the test rates that banks assess borrowers on. Even though you take out a mortgage at 2.5% interest, for example, banks test your ability to repay on a rate that is 3% or 4% higher, which means 5.5% to 6.5% currently. They want to know that customers can afford to pay that should rates rise. If rates rise to 4.5%, for example, borrowers will be tested on 7.5% to 8.5%. It sounds harsh but is designed to protect people from defaulting.

Lifestyle creep

One thing banks know, is if households have spare cash they’ll spend it, not save it or pay down the mortgage. Lifestyle creep, where we spend more when we earn more is a fact of life and it’s the reason we never seem to have spare money, no matter how many pay rises we get.

The other thing banks know is that when people buy houses, they only ever consider the fortnightly or monthly mortgage repayments. Owning a house comes with more expenses than renting. You’ll need to budget for council rates, insurance and maintenance.

Even investors are feeling the pain

Investors are also feeling the pinch. That’s because it’s common for investors to take out 30 year mortgages with the first five years on interest only repayments. When investors start paying principal after five years the higher repayments are compressed over 25 years, which can cause financial pain.

The good news

Clouds have silver linings sometimes. Rising interest rates could have long term benefits for the housing market. First home buyers who were blindly paying $1m or $1.5m for a home not worth it might not be willing to buy now, which could help stop the endless rise in house prices. Sitting back for 12 to 24 months and assessing the best course of action might pay off. If prices go sideways not up and your income and deposit rise, homeownership might become easier.

Changing rules

Navigating through the changing rules within the banks currently is tricky. People often believe they can go to their bank and just be approved. That’s not the case. Banks each have their own set of rules and must comply with responsible lending requirements under the Credit Contract and Consumer Finance Act (CCCFA)

As a broker Global Finance has access to all the major banks. Our advisers know the lending criteria of each and can assess your individual circumstances. We can tell you how much you can afford and which bank’s lending criteria you fit best. Our advisers will also help prepare to give the application the best chance of success.

**These are general guidelines and are by no means a reflection of bank or lending policies