Do millennials really have it tougher in the housing market?

The RBA has lifted rates by 0.5% to 0.85%, and there are more rises on the way. And nothing like a rate rise brings about the clamour that back in my day, interest rates were 17%. While talk of cutting back on smashed avocado dogs millennials struggling to get into the housing market, two of our experts recently evaluated the question – is life actually harder for millennials?

Transcript

Kat Clay: The RBA has lifted rates by 0. 5 percent to 0. 85 percent and there are more rises on the way. And nothing like a rate rise brings about the clamour that back in my day interest rates were 17%. While talk of cutting back on smashed avocado dogs millennials struggling to get into the housing market, two of our experts recently evaluated the question, is life actually harder for millennials?

I’m Kat Clay, and with me are Brendan Coates, Economic Policy Program Director, and Joey Maloney, Senior Associate. we might need to start by declaring some vested interests here. I suspect we’re all millennials.

Brendan Coates: Loud and proud. That’s right, Kat. I still claim to be young enough to represent young people, although those days are numbered, I suspect.

Kat Clay: I know I feel like Brendan, and I at least are elder millennials, as they say on that cusp. Now, before we get into rate rises and millennials, we’re in the middle of our end of year financial giving campaign. We’re a not-for-profit organization, and we do rely on donations from our lovely listeners like you just to keep our podcast going.

If you enjoy this podcast and our research, please give generously at grattan.edu.au/donate. So, Brendan, let’s get into the rate rises. Where are rates going and why is the RBA raising them so

Brendan Coates: quickly? Thanks Kat. So, rates have risen from 0. 1%, like this is the cash rate that the Reserve Bank sets when setting monetary policy, to 0.

85 percent in the course of the last two months. and most economists are expecting that they’re going to hit You know, somewhere between two and a half, three percent by the end of the year. if you believe financial markets, which, you can bet on where you think the cash rate will be, over the course of the next couple of years, we could be looking at a cash rate of four percent, by early to mid-next year.

And the, those markets have actually had, a reasonably good, track record and actually predicting where rates go. So, we should take it seriously. The reserve bank governor went on the 730 report, ABC sort of flagship current affairs program this week. And flagged that he thinks, inflation is going to get higher than they forecast.

Inflation was 5. 1 percent in the March quarter. So that’s it’s like looking in the rear-view mirror to work out what’s happening to inflation. So, inflation today is probably stronger. He thinks it will hit 7 percent by the end of the year, which is what he said on 7. 30 this week, which is a really unusual intervention.

And so basically the Reserve Bank’s really worried about where inflation is going to go. It seems to be overshooting in Australia. Where the forecasts are. It’s been overshooting basically every time a central bank has forecast inflation in the last year in Australia and around the world. It’s been higher.

Inflation in the U. S. is at a 40 year high. That’s because obviously there’s demand side factors, so where there’s lots of demand in the economy, so lots of money chasing. Not that many goods. And then you’ve also got these supply shops. So, you think of the supply shop has been like, when bananas get crops get wiped out by cyclone, you can think of these three cyclones ravaging the global economy.

There’s all these COVID supply chains disruptions the last few years. There’s the fact China’s back in lockdown, in various parts because they’re basically using the wrong vaccines and they’re aiming for COVID zero. And then, you’ve had Putin start a war in Ukraine. and that’s just seen energy prices spike.

And those things You know, inflation is running really strongly. and the reserve bank’s pretty worried about it.

Kat Clay: Brendan, what is the risk here that we actually crash the economy with these rate heights?

Brendan Coates: this is always a risk when you’re thinking about when you’ve got strong inflation, like central banks, their job is to manage the cycle, but they quite frequently, particularly in history, have ended up causing recessions by making mistakes and certainly things that look like mistakes in hindsight.

Often, it’s pretty hard to tell at the time because it’s a really uncertain business. The economy is doing, starting from a pretty good place. Unemployment’s the lowest level in, decades. The labour force participation rate’s basically at its highest level in decades. We’re starting from a really strong place.

We’re basically at full employment, if not, slightly beyond it. Now, the concern is always, oh, this means those rate rises will mean that we’ll crash the economy. But I don’t think that’s probably the most likely outcome. The most likely outcome is people who borrowed, and we just talked about this in a previous podcast, people who borrowed four or five years ago, they’ve actually saved a lot of money.

Their household debt is less. They’re not going to be that affected by interest rate rises because they’ve often Kept paying the same repayments those that borrowed recently, which is a cohort. I think we’re going to talk about in the podcast. They’re at great risk because, interest rate rises mean they’re spent.

They’re spending a lot. I think the bigger risk is actually that you see house prices fall, which, as a homeowner, I don’t love that. But as a policymaker, I think it’s not necessarily a bad thing. And the risk is that in time, that means people feel less wealthy. They spend less. And that’s actually the thing.

That might see consumption fall and see a real us really put the brakes on. But Lowe has said he’ll do what it takes as RBA governor. And if it’s to get inflation back to that two to 3 percent band, and that could involve some pretty severe rate hikes, like the kind of cycle we haven’t really seen since just before the global financial crisis.

And before that, in the early 1990s, when interest rates hit 17%.

Kat Clay: And we’re going to talk about that 17 percent rate in a minute with you, Joey. these rates do look comparatively low to the ones decades ago. Does it still mean that borrowers have it comparatively easy?

Joey Moloney: It’s tempting to, to take that away from the headline numbers.

Look at this hiking cycle and maybe the cash rate rests at about 2. 5%, which could mean that your average, your typical variable home line rested about 5%. That is obviously well below the peaks of 17 percent that we saw at the turn of the 1990s. 17 percent seems like a sort of otherworldly number. There is a lot more to the story if you’re asking, how difficult was it to manage your mortgage?

Interest rates are just one factor. in, calculating what a mortgage burden actually is for a household, which is how much of their income they actually have to spend on servicing their mortgage. That’s what really matters, right? That’s what we’re talking about here. Your mortgage burden is a function of your income, how big your loan is, and the interest rate being charged on that loan.

So certainly, on the last of those, things look like they were much harder for the previous generation. But it was the second last of those, loan sizes, that complicates this story a lot. So, for the older generation, loans were much smaller relative to their incomes, because house prices were much lower.

Now this really helped contain their mortgage burdens. And obviously the reason why the new generation is taking on much bigger loans is because house prices have risen so much. Back then they were about four times average incomes. Now they’re about eight times. So, when you do the math on this, the huge increase in the actual volume of debt households have taken on has really changed the game.

And it’s changed what a given interest rate actually means for household mortgage burdens.

Kat Clay: So let me see if I’ve got that straight. Does that mean high rates now are what low rates used to be?

Joey Moloney: That’s essentially what’s happened. So, in our article that we published last week, we had a graph that showed the relationship between prevailing variable mortgage rates and what that actually translates to in terms of, mortgage burden.

So, the percent of your income that you are spending on your mortgage interests. I’d highly recommend going and having a look at that chart in the article. I think it really cuts through.

Kat Clay: And if you do want to have a look at that chart, you can at grattan.edu.au and it’s there on our news page. So, check that out if you’re curious about the chart that goes with this story.

Joey Moloney: So, what the chart shows is that for any given interest rate, the share of income going to servicing your mortgage is much higher because the loans are bigger. So, another way to think about this is to ask the question. If different interest rates have different implications now, what’s the equivalent of that 17 percent peak that we saw at the turn of the 1990s?

It turns out that 7 percent now is what 17 percent was then, in terms of how much of your income actually has to go on your mortgage. That 10-percentage point gap is broadly the result of loan sizes or house prices growing much quicker than incomes. Now at this stage, it doesn’t look like we’re going to 7%, But you can see how what looked like small increases now, historically speaking, can hurt much more than they used to.

Brendan Coates: But Joey, it’s worth pointing out, if the cash rate hits 4 percent or just a bit higher, which is what financial markets are predicting, the average mortgage rate will probably be about 7 percent because that net interest margin, what the gap between the cash rate and the banks is normally about two and a half percent.

For new borrowers, because they give a better deal to new borrowers, but for existing borrowers, it’s closer to three. I think that’s why we have to take this relatively seriously, because those predictions have not been unreasonable in the past. And they would imply that we’re going back to a world that looks a fair bit like 17 percent based on the kind of numbers you’re talking about.

Joey Moloney: Yeah. I think that’s a fair point. 7 percent is probably at the upper end of estimates. if you look at bank forecast seemed a bit more bearish than what the, the bond markets are pricing in, but it’s not outside the realm of possibilities that a variable mortgage rate is hitting 7 percent by the end of next year.

Brendan Coates: Yeah. It’s actually worth noting when Phil Lowe went on the 730 reports, he’s talking about trying to get interest rates to what he thinks is what they call mutual, which is like where that’s headed up. Stimulating the economy or helping the economy contract. And he thinks that you mentioned 2.

5 percent cash rate. So if he thinks neutrals about five for the mortgage rate, maybe a little bit higher than a cash rate, an interest rate on mortgages of 7 percent isn’t like it’s probably it’s hopefully not as a, borrower, as a, as an owner, it’s hopefully not the number we end up with. If we end up there, it’s because inflation keeps surprising.

On the upside in Australia, as it has elsewhere around the world.

Kat Clay: Apart from having a mild heart attack, over here is the podcast host thinking of my mortgage repayments being at 7%. The thing that I was thinking about, Joey, when you were talking about that comparison, is like Take two cakes, for example.

you’ve got a three-tier wedding cake, and you’ve got a cupcake. Eating half of each of those is going to be two very different quantities there. So that’s what I’m thinking in terms of these mortgage repayment comparisons. a lot of people are borrowing a lot more these days. Joey, there are people who say, it was, really difficult at 17 percent and people remember repaying their mortgages in the 1990s.

So how hard would it have been if you borrowed back then?

Joey Moloney: Very hard. And no one is downplaying that. Certainly not me. Like I said, 17 percent then is 7 percent now. But the way to think about this is that it didn’t last for that long. If we take someone who borrowed at the peak in 1990, they would have experienced throughout the sort of early part of the nineties through to the end of the decade, interest rates falling a fair bit and incomes growing.

So those two effects together can have a pretty profound effect on one’s mortgage burden. When you model a borrower from 1990 at all the average incomes, average typical variable interest rate, what you can say is that They would have started their mortgage with a very high burden, would have been north of 30%, which is the typical benchmark for housing stress.

That fell within a few years that would have fallen below 30 percent and probably by that halfway through the mortgage, you’re down at around 12%. So, you can see a pretty rapid decline in mortgage burden as the mortgage went on. That’s because you’ve got a small loan with a high rate with a small loan, with a high-rate rates can go down.

So, there’s a release valve there. It’s a bit of a different story. If you’ve got a big loan with a low rate, you might, you don’t really have that same release valve of rates coming down.

Kat Clay: And there’s only so many entertainment subscriptions you can cancel before things start to really crunch the numbers on your home budget.

So, Joey, big loans at low rates sounds like a new generation of borrowers. It might even sound like myself, if I’m being honest here. We shouldn’t expect things to get easier in a hurry here.

Joey Moloney: Look, not to sound too negative, but probably not. At least not compared to that previous generation, say that 1919 borrower that I was talking about before.

Like I mentioned before, the things that affect your mortgage burden there, the loan size, the interest rate, and the income. The loan size is what it is. When we look at a borrower, say he borrowed, late last year, like that cohort Brennan was talking about before, those who borrowed at ultra-low rates at the peak of the housing market.

You make reasonable assumptions about the future, Mortgage rates settle, maybe like even five, which is pretty, maybe slightly optimistic. Incomes grow at 3%. You wouldn’t expect the mortgage burden for that borrower to decline at a particularly ripping pace. It’ll fall over time, as is the nature of these things, but at a much slower pace than we saw for those previous generations.

Brendan Coates: I think it’s, also worth just noting, Kat, that, if you’re thinking of your own situation, and I, we’ve bought.

It’s the analogies like we bought the equivalent of 1988 and then interest rates jumped, and you experienced that pain right as interest rates jumped and then they fell. And, depending on what happens in these couple of years. They could fall, but I think what Joe is saying about it, the long-term being the burden being higher is likely obviously as interest rates rise, house prices will fall.

So if you happen to buy next year or the year after, the burden could potentially look a bit different because obviously then you’re not paying as much because you’re, catching it, hopefully, depending on what happens when interest rates are on the way, potentially on the way down or have stabilized.

I think the reason not in a 1990 is such a searing experience is not probably for people who bought in 1990. It’s probably for the people who bought in the three years prior, which is the analogy we’re thinking about for people who bought in the COVID period and then experience higher rates.

Now in an ideal world, Australia is unique in that we all pay variable rate mortgages. That’s actually really rare Globally, so in New Zealand in the US you basically whatever interest rate you take out It’s normally fixed for 30 years That’s why we actually are probably more exposed and it’s a question that I think we should ask ourselves is in a world Where rates are gyrating around And house prices are moving so much in a world where debt is quite high.

Does it really make sense for everyone to pay fixed rate mortgages? Now, obviously, we’ve just benefit from the downside of that if you bought. And now we’re whinging about it on the way back up, but it does raise questions about do you really think households are the best place people to do this? Should we have more fixed rate mortgages in Australia of longer terms?

Because I tend to think we probably should.

Kat Clay: So, Joey, big question for you. Is it time to cut millennials some slack?

Joey Moloney: Definitely. And this is probably where that conflict declaration at the start really hits the road. But, yes, skyrocketing house prices have really changed the game. Yeah, you can’t just compare yesterday’s interest rates to today’s, given the change in the volume of debt that the, the new generation’s taking on. These rate rises aren’t going to be hard for millennials because they spend too much money on particular fruits spread on toast. It’s going to be because they’re more indebted than their parents were, basically, because houses are so much more expensive, I might just finish by making a broad, a broader point, which is that in a lot of ways, the current generation, our generation is better off than the previous generations. And we should be honest about that. international travel is more accessible. Electronics are a lot cheaper, as is the nature of economic growth and technical technological progress.

Each generation is generally better off than the one before it. It’s just that housing costs are clearly an area where millennials. are facing some challenges that the previous generation didn’t, at least not to the degree that this generation is. So, I just think it’s important to have an honest conversation about that and I might finish up there.

Kat Clay: So, Joey, what’s the name of this piece you’ve been talking about today and what publication was it in originally?

Joey Moloney: So, it was called The Housing Game Has Changed and Interest Rate Hikes Hurt More Than Before. And it’s in the conversation.

Kat Clay: And if you do want to read that, please go to grattan.edu.au/news.

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