Why your home loan rate is heading higher in 2017

Jan 2017 - News

The experts are saying it’s time to brace for higher mortgage rates.

The good old days of Reserve Bank of Australia rate cuts and banks falling over themselves to get your business appear to be behind us as the world prepares for a future of higher interest rates. The banks are already jacking up fixed rates and rates to investors in anticipation of this situation.

But is your home loan rate really going to go up in this year and, if so, by how much?

Well it depends on several variables, some of which are market and industry related and hard to predict. Global bond rates, RBA policy and market volatility have a marked influence on the interest rate you will pay this year.

But so too will the extent and intensity of competition for new loans, deposits and how global bank rules will be applied locally.

And it will also depend on the type of loan you have – whether it’s fixed or floating, investor or owner occupied or interest only – and who you are borrowing from. For that reason, it’s a question we have to ask in parts.

Standard variable home loan rates

Let’s start with the most common form of home loan, the standard variable home loan rate. To work out if it’s going up or down, let’s first identify the ingredients.

A bank sets your home loan rate at a (profit) margin above its funding costs, which are made up by the cost it must pay for deposits (which account for 60 per cent of its funding) and wholesale debt sourced in the capital markets (which account for about 30 per cent).

The ingredients, therefore, are: the level of base short-term interest rates, the spread above that rate it pays for deposits, the spread it pays for wholesale funding, and the additional profit margin it wants or is able to charge you.

Wholesale funding spreads

First let’s examine credit spreads. On the surface they should not matter too much. Credit spreads are the risk premium the bond market charges the banks for funding over and above the risk-free rate. If they see risk in the banking sector rising, or volatility and uncertainty in global markets rising, they’ll charge more. Over the past five years, bank funding costs, as measured by five-year credit default swaps, have moved from as low as 45 basis points to as high as 200 basis points.

Right now, the election of Donald Trump as US president and fears over Brexit are having no negative impact on credit spreads.

In fact, NAB and ANZ hit the bond market earlier this year and paid relatively decent rates for five-year funds in the US markets.

Credit spreads paid in the wholesale market also don’t matter as much because wholesale funding accounts for 30 per cent total funding (about 20 per cent short term and 10 per cent long term). Long-term funding is most sensitive to credit spreads but, since it’s long term with an average maturity of four years, only about a quarter needs to be refinanced every year and is subject to higher costs.

If wholesale credit spreads do spike, it will impact a fairly insignificant proportion of the bank’s funding books and shouldn’t move the dial.

Well that’s the theory but the reality is a little different. The banks may only need to replace a relatively small proportion of long funding in the bond markets on any given year, but that’s still $100 billion of it, given the enormous size of the banks’ loan books. It’s a big task and, if markets become hostile, they run into difficulties, not about the cost of funding, but funding at any cost.

Deposit funding the main game

That brings us to deposits, which account for 60 per cent of the banks’ funding books. That seems like a lot but it’s actually a low ratio relative other developed banking systems where the level of deposit savings just about matches the amount of loans they extend. The nation’s appetite for debt exceeds its appetite to save, which means we have a funding gap that must be plugged by wholesale funding.

If a market panic impedes the access of Australian banks to the wholesale markets (which can and does happen), they are left with little choice but to turn in desperation to depositors to cover the funding short-fall.

And if they’re paying more for the marginal deposit dollar, they have to offer that rate to everyone. Their whole deposit book goes up, almost immediately. While only a small portion of wholesale funds are refinanced every year, deposits are short term. That means 60 per cent of the banks’ funding books are repriced several times throughout the year, which means it feeds through to bank funding costs immediately.

Deposit costs not rising, yet

So are deposit costs rising? Not really. There were signs that competition in the deposit market was heating up in the middle of last year as rates fell to extraordinarily low levels after a second Reserve Bank cut, but since then the evidence is the banks aren’t having to pay a meaningful premium to attract savings.

Deposit rates are notoriously difficult to forecast. But one factor that can drive them higher are new banking rules that formalise the importance of deposits, which regulators have come to recognise are the stickiest form of funding (the least likely to be withdrawn). The banks are required under new rules to maintain a “stable funding ratio” that prioritises retail deposits.

That means it’s possible a bank won’t be able to write a new home loan until it has raised a deposit to fund it. So the growth of banks’ loan books and their business will be determined by their ability to gather deposits, so they may pay for them, forcing up the cost. This will be an issue to watch in this year.

Bank returns under pressure

The other variable is the profit margin banks are demanding from their customers. The banks measure their return on equity for a home loan as the spread they charge for the loan, minus their cost of funding, divided by the amount of shareholder capital set against the loan. Some analysts have worked on the assumption that the banks seek to maintain a 50 basis point profit to achieve a 40 per cent return on equity (the return on equity for the broader major bank is lower at about 15 per cent because of the other lower-return lending it engages and because of the broader costs of running a bank).

In recent years, the banks were forced to raise their equity capital levels against mortgages, which significantly reduced their return on equity. So to restore them they simply raised home loan rates (and wore the furore) to a point where they achieved a 40 per cent return on equity on the loan. If the banks are forced to raise more capital (some analysts say they will, others say they won’t), we may see them raising variable rates again.

Also, if funding costs go up, the banks will need to raise the home loan rate accordingly to maintain their profits.

But that assumes the banks have the pricing power to be able to simply raise prices as they see fit. (It’s a fair assumption given past experience.)

Competition may put a lid on rises

What we may see this year is more competition for home loans as banks battle it out for market share and for new loans in a slowing credit environment. They may very well have to accept lower returns on equity to maintain market share and absolute dollar profits. The early evidence suggests this is not the case as the deep discounting of home loans we saw last year appears to have abated.

Which bank you borrow from will also matter because their respective funding mixes differ.  It’s interesting to note that, at the moment, there has never been a greater variability in the rate that banks are charging for home loans. This is a function of the different funding mixes of small banks (that are deposit heavy) versus regional banks (that have an expensive wholesale funding component) and large banks (that have market power but are under pressure to raise deposits).

Finally, variable funding costs are a function of base short-term interest rates, as both funding and deposit costs and the home loan rate is calculated by the bank as a spread above the bank bill swap rate. There’s been some debate about the relationship with the Reserve Bank cash rate and the BBSW, but broadly it holds that the BBSW (which is the cost banks pay each other for one to three-month funding) tracks the RBA cash rate. If the cash rate goes up, the standard variable rate will likely at least match it.

RBA rate rise in 2017 priced at one in three chance

So what are markets pricing in for the cash rate this year? Well, for most of last year it was cuts, but that all turned in the third quarter of last year. As of this week, the expectation is that the cash rate will be steady but with a one in three chance that, by December, we may see a hike.

If we weight that by probabilities, expect an 8 basis point rise in your standard variable rate.

So, in sum, there are lots of moving parts. At the moment there’s no good reason to see an increase in your standard variable rate. If markets panic, it may go up. It may go down, too, if it’s bad enough to force the RBA to cut rates. But, by the same token, if the banks are competing harder for your loan, you may see the benefits of lower pricing.

Fixed home loan rates

How about if you have a fixed rate loan?

Well, if you have a fixed rate loan, it’s not going up. It’s fixed, remember, so, until it rolls off, there’s no increase.

But what is absolutely happening now is that, if you are applying for a fixed rate loan now compared with six months ago, it’s gone up sharply. The reason is fairly straightforward: three-year and five-year global bond rates have moved sharply higher.

More or less, when a bank writes a fixed rate loan, it goes into the interest rate markets and secures the funding for the term of the loan, then forgets about it. For example, for three years it will earn 4 per cent a year and pay 3.2 per cent. What happens from that point won’t affect the profitability of the loan, but it will affect the price of future loans as it fixed the funding and the profit at that point in time.

The price the bank pays for three-year fixed-term fundings equates to the three-year swap rate (which is like the three-year bank bill rate) plus the credit spread.

The swap rate more or less tracks what the government bond rate does and, for the past five years, it’s been falling sharply because of global deflationary fears and negative interest rates. It got as low as it could possibly get in September last year, to the point where the Australian banks could secure three-year funding for about 2.5 per cent (the three-year base was 1.75 per cent), and therefore offer very attractive fixed rate loans to their customers.

But then the bond markets took off from their extreme levels in what was known as a bond rout as the three-year rate spiked to 2 per cent. Trump’s election win brought about it more expectations that his spending plans would fuel more inflation, and it kicked up Australian bond rates by another 35 basis points to 2.35 per cent. By coincidence, the three-year rate is at the same level it was at the start of 2016 and 2015. In January 2014, it was 3.2 per cent.

You’ve already missed the best time to fix

So this means that you’re likely to pay, all things being equal, about 70 basis points more for a three-year fixed rate loan now than you would have a few months ago when, with the benefit of hindsight, it was a great time to fix.

The expectations, and they’re not always right, is that bond rates will move higher from here, which will force up bond rates and therefore fixed rate loans. But we don’t really know for sure and, at the start of this year, traders are already questioning the extent to which bond rates will rise.

So that explains what will drive your mortgage rate in this year.

Investor loans

There’s one other point that needs a mention. Do you have an investor or owner occupied loan?

Last year, for the first time, the banks began to charge different rates depending on whether you were living in your home or renting it. That’s because regulators became concerned about the growth in investor loans, which they concluded could make the housing market more volatile as one is far more likely to sell an investment property in a hurry than a home. The banks had speed limits imposed upon them as to how quickly they could grow their investor loan books. One way to slow growth and make more money at the same time is simply to charge a higher rate for investor loans, which some of the banks have done.

The extent to which rates on investor loans rise, relative to owner-occupied loans, is therefore likely to depend on whether this segment is growing too quickly for the bank in question relative to the regulators’ desires, and whether there is renewed competition from banks that are under the speed limit. Again the evidence is that there’s no slowing in sight, which means the banks, and even policymakers, may need to do more to moderate demand.

So will your mortgage rate go up in 2017? The odds are it will, but it’s not a done deal



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