The central bank has warned that a small group of borrowers could fail to meet debt payments due to low savings and high levels of debt, leading to higher arrears.
The Reserve Bank of Australia’s (RBA) Financial Stability Review for October 2022 has revealed that higher interest rates will increase borrowers’ debt payments.
Households have been left with less capacity to service their debts despite a strong labour market because income growth has not kept pace with inflation in Australia, it said.
While many households will be able to manage this by reducing their spending and/or rate of savings, the central bank flagged that a small proportion of borrowers with lower savings and high debt are vulnerable to payment difficulties due to rising interest rates and cost of living pressures.
Many of these households have low liquidity buffers, low incomes, and high debt relative to their income.
“As a result, housing loan arrears rates are likely to increase in the period ahead from currently very low levels,” the RBA said in its review.
“Debt servicing challenges will become more widespread if economic conditions, particularly the level of unemployment, turn out to be worse than expected and housing prices fall sharply.”
In its overview, the RBA said that some households have already been feeling the pinch from rising interest rates and inflation and flagged that this could continue for some time.
However, most borrowers have accumulated substantial equity in their homes, reflecting the large run-up in housing prices over recent years and the small share of high loan-to-value lending, which could ease financial stability risks if the borrower was to face debt-servicing difficulties, it added.
The combination of higher interest rates and inflation will squeeze household budgets, which is likely to lead to a ‘turn’ in the credit cycle following a period of very low loan arrears — including for lenders in Australia.
Furthermore, the RBA noted that a large decline in housing prices that results in negative equity for households along with additional shocks to disposable income, would increase the risk of some borrowers defaulting on their loan commitments.
A fifth of variable rate borrowers face mortgage stress
Meanwhile, among variable-rate mortgagors — which account for around 65 per cent of outstanding housing credit — around 20 percent of borrowers will have their minimum loan payments increase to more than 30 per cent of their incomes, while 15 per cent would see less than a 20 per cent increase in the dollar value of their monthly payments relative to their average payments over the past year.
Over 40 per cent of variable-rate borrowers would not have to increase their payments at all relative to their average payments (including excess payments) over the past year.
Over half of borrowers with owner-occupier variable-rate loans would see their cash flows decline by more than 20 per cent over the next couple of years, including around 15 per cent whose spare cash flows would turn negative.
The RBA said that it expects a larger share of households to fall into arrears on their mortgages if labour and housing market conditions deteriorate further than assumed in the bank’s central scenario.
However, it also said that “while a relatively small share of the sample of households appears to be at high risk of falling behind on their loan payments, most borrowers will likely be able to manage for at least two years by reducing their non-essential spending, reducing their saving flows and/or drawing down on their accumulated prepayment buffers”.
The RBA said it expects bank balance sheets to remain resilient to an increase in loan arrears “under most plausible scenarios”.
“However, in some economies, a turn in the credit cycle could test the resilience of some lenders (including smaller banks and non-banks) — particularly those with relatively low capital buffers and high leverage, and/or whose lending standards have slipped in recent years,” the central bank said.
Banks also remain liquid and well-capitalised, with the RBA stating that large capital buffers would cushion them in the event that non-performing loans pick up from their very low levels in the period ahead.
Non-bank lending has remained very strong, with the RBA underscoring the importance of lending standards remaining prudent.
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