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What’s Going On With Interest Rates?

Date: 10/11/2017

Melbourne Cup day produced a few surprises, but none of them was the RBA’s decision to keep its cash target rate at 1.50% – a historic low and where it’s been for the past 18 months.

However, just because the RBA has not increased its cash rate for well over a year, doesn’t mean that home loan interest rates have been be-calmed too.

In this article we’ll examine how liquidity in the finance market acts as either an accelerant or a braking mechanism to property prices, and in doing so, we’ll identify some curious bank behaviour that could be setting us up for the (eventual) property price crash we have to have if younger generations ever hope to own a home.

Liquidity

Let’s start our discussion with a quick chat about liquidity.

Liquidity is a measure of the availability of (or access to) cash. An increasingly liquid finance market means that it is getting easier to borrow money. With easier access to more finance, borrowers can afford to pay more for assets, and this leads to upwards pressure on house prices.

A tightening, or increasingly illiquid, finance market means it is becoming harder to borrow money, and this tends to put downwards pressure on property prices.

↑ Liquidity = ↑ Property Prices

One of the reasons why property prices have been able to increase rather rapidly over the past decade or so has been the invention and re-invention of practices and products that have facilitated more liquidity in the finance market.

It all started with the de-regulation of banks in the 1980’s, and with it the demise of the rigid lending practices that your parents and grandparents grew up with. Things like needing a good reputation and savings history to open a bank account, and that if you got a home loan it was for 50 – 70% of the property’s value, and it had principal and interest repayments that you chipped away at to repay the loan over 25 years. De-regulation gradually did away with much of this, and redefined the ‘standard’ loan to be one with more flexibility and choices.

Non-bank lenders like Aussie Home Loans, RAMS and the like sprang up like magic mushrooms, and with it creative finance propositions were born – like the invention of low-doc loans where you didn’t have to prove your income, but rather made a declaration that it was so. Such loans opened up borrowing avenues for people in small business and with diminished credit worthiness to access finance (and buy assets) that they would not previously have qualified for under the old regime. More Borrowers + More Debt = Higher House Prices

Liquidity is like salt – a little brings out the flavour, but too much spoils the food. That is, a certain level of liquidity (i.e. access to debt) is needed for the property market to function normally, because real estate is not a commodity most people can buy without using debt. However, too much debt, or debt that is too easy to access, can cause an asset price bubble, which are fun while they last, but horrible when they pop because they can lead to nasty recessions, and even depressions.

Runaway liquidity was the reason why suit-wearing regulators in glass office towers became concerned that access to credit was getting a little too loose. In response, consumer credit laws were tightened, and this caused (for a time) the brakes to be applied to liquidity. House prices stalled.

However, humans are a resourceful lot, and with low-doc loans now out of favour, interest-only loans became as popular as a kid giving out free candy at lunchtime because it allowed borrowers – and chiefly investors – to be able to afford to borrow more (because there is no principal repayment), and this in turn allowed property prices to drift even higher.

Investor speculation was also becoming problematic. Home owners make better borrowers because they are thought to be ‘stickier’ with their finance commitments (because they own their home and hence have a physical and emotional connection to it). Investors however, particularly those who are speculating and are steadfastly borrowing imprudent amounts (i.e. > 80% LVR), have a tendency to go belly up when markets wobble, and if investors become insolvent en masse, then that could disseminate a whiff of panic and trigger a sale stampede, which in turn could cause property prices to be trampled.

Reality Check

Which brings us to where we are today…

  1. Historically low interest rates have increased liquidity by making it more affordable to borrow higher sums of money

  2. In a highly competitive finance market, lenders have been actively competing on price and service, and are spruiking low loans and easy applications in an attempt to get more customers, and to facilitate higher borrowings, in order to secure upfront and trail commissions; and

  3. News headlines about instant property millionaires being made – particularly in Sydney and Melbourne – have stimulated speculation and enticed more people to take risks

It’s no wonder property prices are increasing: borrowers are frothing at the mouth to get access to cheap and easy finance, and are using it to speculate on property. Bubble bath, anyone?

Our Protectors

Standing in the way of all-out capitalism is the RBA and another government authority: the Australian Prudential Regulation Authority (APRA).

The RBA, hamstrung by low inflation and a hiccupping non-housing economy, can’t do much except jawbone enthusiastically to warn property investors not to get too drunk on cheap finance for fear of the debt hangover that will surely happen when interest rates eventually start to rise.

APRA on the other hand has been more effective. By pulling and pushing the levers and buttons they have at their disposal to regulate bank lending practices, they’ve put the brakes on loans to investors (by limiting the amount of a lender’s loan book that can be allocated to loans for investment purposes), and by curbing the quantum and quantity of interest-only loans (by limiting the amount of debt a lender can provide on interest-only terms).

The False Finance Messiahs

And then we have the banks… those ethical bastions of corporate and social responsibility that have so generously (conveniently?) done the RBA’s work for them –putting the brakes on liquidity by increasing the interest rates they charge on interest-only loans, and on loans to investors, while at the same time calling a competition war on loans to owner-occupiers.

Take Note!

An interesting point to note here is that investors should target a financier who is not covered by APRA’s regulatory regime as they should be able to get a better interest rate, and better loan terms. That’s why we recommend you connect with the guys we’ve partnered with via www.PropertyInvestingFinance.com

Paying The Piper

Aside from propping up bank profits (where it seems there is no ceiling on greed under the guise of “value to shareholders”), having the banks apply the brakes on liquidity (on the RBA and APRA’s behalf) is likely to have serious consequences once the RBA does start to increase its cash rate.

This is because the margin between the cash rate and the home loan rate, which used to be approximately 100 basis points, is now 380 basis points. This margin has gradually crept up under the auspices of more expensive capital (during the GFC, now long gone!), the importance of banks being profitable (Oh please! How much is enough?), and helping us by making loans more expensive for investors to prevent a possible property crash (thanks – not!).

Here’s the question… do you see the banks allowing that inflated margin over the RBA’s cash rate to diminish in the future? I don’t, which is why I think the so-called convenience of today will come back as the curse of tomorrow, when inflation is a problem but property prices are soft – the exact opposite of today. Such a scenario could be the perfect storm that triggers a property price crash and a redistribution of wealth from the property-haves to the property have-nots.

So, What Can We Learn From This?

Wrapping up our discussion, here are the takeaways:

  • The low interest rate party is coming to an end. Profiling some borrowers and charging them higher interest rates is like kicking some of the rowdier patrons out of the bar ahead of closing time for all.

  • Investors would be wise to price new / refinanced loans with non-APRA-regulated lenders that are not subject to APRA imposed limitations and can thus offer more competitive finance for such borrowers. You can check out the rate and terms of the team we’ve partnered with at www.PropertyInvestingFinance.com

  • Keep a close eye on factors that affect debt liquidity. In order for there to be a property crash, there will need to be a sudden spike in sellers in conjunction with tighter debt liquidity making it harder to qualify for a loan. That said, any further easing in debt liquidity could fuel further property price rises.

  • The banks’ current willingness to assist the RBA and APRA throttle back debt liquidity for some, may have an unpleasant consequence come the time when the RBA wants to increase interest rates to reduce inflation, but doesn’t want to cause a housing correction (i.e. the very opposite of the situation today).  

 

Profile photo of Steve McKnight

By Steve McKnight

Steve McKnight, the founder of PropertyInvesting.com, is a respected property investing authority as well as Australia's #1 best-selling business author.

Comments

  1. Profile photo of Steve McKnight

    Hi friends,

    I hope you enjoyed the article.

    I thought you’d appreciate a quick update as I just saw this article in the news:

    “Investors are being pushed out of Australia’s housing market with government regulations generating a 6 per cent drop in investor loans as first home buyers record “strong growth” for the first time in years.

    In Victoria, the number of loans to first home buyers grew by an extraordinary 57 per cent since June, with a 32 per cent increase in NSW.”

    This is an example of tightening liquidity caused by government intervention. Without investors house price growth will be stagnant. A supply shock will cause prices to fall as there won’t be enough first home buyers to absorb the stock.

    – Steve

    • - David

      Hi Steve,

      Thanks for the article.

      I am a first home buyer and scheduled to put a deposit down in the coming week, for a Sydney apartment in the northern beaches (off the plan scheduled to be ready on early 2019).

      We know that we are paying a higher price today than if we were to have purchased in 2013/14, however having sat back for years waiting for a correction, we felt we need to pull the trigger and buy. After all, if there was a correction today of i.e. 20%, the price is still higher than it was in 2013/2014, so still more debt.

      Of course I would rather wait for the correction and take any savings, but there are no guarantees on when this could happen. But like your article implies, perhaps the correction is imminent.

      Thoughts on if now is the wrong time to buy our first home (I am buying this as a home, not an investment)?

      Thanks,

      David

      • Profile photo of Steve McKnight

        Hi David,

        If you’re buying the property as a home then I don’t think it really matters. You’ll be able to own through any soft period, and because you are an owner-occupier you will be able to get very competitive financing.

        Remember too that a property correction will result in lenders tightening their credit application / qualification policies, and most likely reducing their standard LVR back to 80% or below.

        I think you are doing the right thing. Just be careful with what you buy to ensure it will hold its value in the midst of a possible glut of apartments coming on the market. It’s not location, location, location that is important, but rather scarcity, scarcity, scarcity.

        Regards,

        – Steve

  2. Kerry King

    Great article Steve. I only wish more people could read it. A lot of sobering truths here. At least the people who got caught up in the housing aspect or the ‘mining boom’ have already taken their punishment. Now it seems the rest of Australia will take some pain soon enough.

  3. Adam Coates

    Wow Steve – a lot to digest – for there is more than the mere words you have used. Love the analogies by the way… “Closing time” :-) I learn more with each article and whilst suspected a rise in the near future you made clear the repocussions of each factor involved. Love your work. Keep it up

  4. Vanessa Crago

    Hi Steve

    I’m confused as this “In order for there to be a property crash, there will need to be a sudden spike in sellers in conjunction with tighter debt liquidity making it harder to qualify for a loan. That said, any further easing in debt liquidity could fuel further property price rises.” seems to contradict itself.

    Can you please elaborate? Loved the article overall – thanks!

    • Profile photo of Steve McKnight

      Hi Vanessa,

      For there to be a property crash there needs to be a lot of sellers looking to exit, and at the same time few as buyers wanting to purchase. This will cause sellers to reduce their price in order to entice the few buyers in the market to act.

      Tighter liquidity means that it will be harder for borrowers to borrow money, and this is usually the circumstance when there is a credit squeeze. Lenders, if they are willing to lend, will probably demand a higher deposit in addition to an excellent credit rating and history.

      So when you have a downturn you usually have a spike in sellers (wanting to exit) and a drop in the number of buyers (because it is harder to qualify for finance).

      On the other hand, should credit become easier to get and/or lenders allow higher LVR loans, then that liquidity easing will bring more buyers to the market who can pay more for property (as they are borrowing more) and hence can push prices higher.

      Hopefully it makes more sense now.

      Bye,

      Steve

  5. Josh McBrien

    This is really interesting to read and gives me a lot of conflicting thoughts.
    I have known for years now that this is on the horizon, quite frankly anybody who keeps up to date with the economic climate can see the storm brewing also.
    Much like what David said, I am going to be a first home buyer (rentvestor), with the intention to purchase in 2018. However I now find myself caught between getting a foot in the door, or waiting for the inevitable lightning to strike, the lightning I’ve now been waiting 18 months for to secure a property once the correction has hit.
    It just makes me wonder how much longer it will be before the banks pull the trigger on interest rate rises, as I went into Commonwealth Bank a month ago, where they advertised 1, 3 and 5 year fixed rates all at 3.??%, yet 7 year at 7.??%. How much longer do they perceive rates will stay this low for?
    The euphoria seems beyond belief to me; with euphoria comes high emotion & irrationality, which leads to impulse decisions (selling out of fear). It’s not a matter of if, but when?
    Yet that is the question that can’t be answered…

  6. Profile photo of janecav

    I love “Liquidity is like salt – a little brings out the flavour, but too much spoils the food. ”
    So entertaining and informative to read. Thanks Steve!

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