Sydney & Melbourne House Prices: Can changes to your Borrowing Capacity predict what happens next?

In recent years, Sydney & Melbourne median house prices have shown a close correlation to borrowing capacities. The more one can borrow, the higher the median house price will be. Therefore, understanding borrowing capacities provides some insight into the direction of house prices. The purpose of this post is to take a deeper look at understanding, analysing and forecasting borrowing capacities.

Over time and all else equal, actual borrowing capacities generally increase a little bit every year. In recent years, borrowing capacities have fluctuated dramatically due to repeated policy interventions.

In 2018, reductions in borrowing capacities came from higher benchmark living expenses. This led to approximately a 14.2% fall in household borrowing capacity (peak to trough). Thereafter, in 2019, APRA removed the pre-existing 7% floor rate and moved to a floating +2.5% rate. There were also the stage 2 tax cuts and multiple interest rate cuts. In 2021, further rate cuts occurred. Overall, the combination of removing the floor rate, lower interest rates and tax cuts,?led to a 55% increase in borrowing capacities (trough to peak).

Data from: Confidence Finance modelling of Borrowing Capacities over time & Domain’s Quarterly Sydney Median House Price Data. Borrowing capacity reflects year on year changes a Sydney high income household earning $160k each in 2017. As background, banks calculate your borrowing capacity by?adding?your household’s after-tax income &?subtracting?their assessment of your household expenses. This calculation results in a ‘net monthly surplus’?figure, which broadly shows how much money you have at the end of every month available to make mortgage repayments. They then determine your borrowing capacity whereby the monthly repayment is equal to your monthly surplus. In calculating your monthly repayment, they assume the interest rate is 3% higher than it is at the time of your loan application.

So what will happen to borrowing capacities in 2022-2023?

Interest rates are one of the main drivers of borrowing capacities. When interest rates rise, monthly repayments increase, and households can borrow less. Given the large increases in interest rates already occurring in 2022,?borrowing capacities will fall between 13.3 – 25% depending on where the cash rate is based on today's borrowing power calculations.?

Data from: Confidence Finance modelling of borrowing capacities & Domain’s Sydney Quarterly Median House Price Data. As at July 2022 with a 1.35% cash rate, borrowing power reductions are around 10% so far.

Nonetheless, current APRA settings are based on an environment of low interest rates. We believe that APRA will reduce the 3% buffer rate down to 2% by mid-2023.??This change alone boosts borrowing capacities by roughly 10% & in turn will reduce the severity of borrowing capacity reductions from interest rate changes to between 3.6 - 17.3%.?

Why 2%? As background, prior to May 2019, APRA had a floor rate (minimum) at 7% and a +2% floating assessment rate above the actual interest rate. To boost borrowing capacities, in May 2019, APRA removed the floor rate and introduced a floating assessment rate +2.5% above the actual interest rate paid. In October 2021, this was increased to +3% to reduce the proportion high DTI loans. We expect the proportion of high DTI loans to dramatically fall in coming months. With this fall and increasing interest rates, there will no longer be a requirement for an aggressive interest rate buffer.

What about after the current housing downturn?

Borrowing capacities have ebbed-and-flowed in recent years. This will continue, with a recovery to borrowing capacities likely by mid-2024. The numbers driving this are largely from the 2024 legislated tax cuts & potential reductions in interest rates once inflation abates.

The above chart shows the potential borrowing impact for this high income household in 2024. It assumes that APRA have reduced the buffer rate down to 2% by then and that legislated stage 3 tax cuts progress. This household receives nearly the full benefit from the tax cuts (gross income at 180k+ by 2024). Borrowing capacities explode, potentially above their 2021 peak level.

Conclusions:

• The above points to a very sharp housing downturn, that will likely be a little bit larger than the 2018 house price falls.?
• Borrowing capacities will likely fall to their 2019 levels if the cash rate hits 2.5%, with Sydney house prices likely reversing all of their post Covid gains. APRA may curtail the size of the house price falls by cushioning borrowing capacities by the middle of next year.
• The analysis suggests a V shaped period for house prices in Sydney & Melbourne. We may be in for a period similar to 2018-2021, with the sharpest housing declines in decades, followed by a very sharp rise. Overall, volatility in borrowing capacities will continue over coming years, with likely corresponding volatility in house prices too. For investors, this may mean opportunities to 'buy low', or retain existing portfolios through the cycles ahead.?
• Changes in values will not be distributed evenly. Borrowing power reductions are more severe the larger the mortgage size. Government grants and benefits assist lower priced homes too. This means that lowest quartile/half homes by value may fall less during the downturn (apartments, etc). However, the 2024 tax cuts are distributed to borrowers who purchase a greater share of upper quartile homes.?
• Melbourne typically follows Sydney house price trends & borrowing capacity movements closely too. Other markets are influenced by interest rate and borrowing capacity changes, but borrowers rarely are close to capacity and so ebb-and-flow to other factors more-so than Sydney & Melbourne.