What would your loan look like @ higher interest rates in Australia?

Prices, prices and more prices.

Property is always on the brain in Australia. We are obsessed.

Whether it is the auction clearance rate, the latest median house price or an upcoming property development, there is always something in the news.

Journalists, politicians, services professionals and property developers alike have been extolling for the last 6-12 months one of two scenarios:

• the bubble, the housing boom, the coming bust and the inflated impending likely fall of house prices; or
• the sky is the limit, the only way is up not down, at worst we'll go sideways.

At the risk of stating the obvious, the ongoing commentary's focus on price is its greatest weakness as it prevents a much-needed dialogue around loan serviceability.

Why does this happen?

Lending involves maths. I personally like maths, however, I accept that it's often difficult to write succinctly and tough to read. Basically, not everyone likes maths.

Society is far more interested in the click bait highs and lows of property prices and how much money people are making or losing on their property right now.

So why read on?

It should come as no surprise to you that consumer lending interest rates are heading up. They've been at historic lows and for quite some time. Up is the only medium term direction they can go, possibly even regardless of Government or Reserve Bank of Australia's (RBA) policy settings. Why? There's a whole other conversation on bank funding that's needed here. For now, put aside that element and let's assume rates are on the rise.

So what?

Well, you love talking about your house and how much it's worth right?

Do you want to keep it?

Then you might want to read on to see where higher interest rates will take you.

Good, you're here.

In reading on, please note the following: this is just an example, it isn't financial advice, and it's certainly not something to rely upon. I do think it provides a good illustration of the potential future for property owners in Australia. So if you have any questions you should seek out financial advice from an appropriately licensed individual. (End disclaimer)

The scenario

Our couple both earn A$80,000 per annum. So with a combined income of A$160,000 they currently pay A$35,094 in income tax and therefore have an after-tax income of A$124,906. Let's ignore bonuses and super for now.

Our couple in their early 30's, and have been looking to buy together in Sydney. They've just won an auction for a property at A$1,000,000 and put down $200,000 deposit which they've been saving for forever and along with a little help from both sets of parents.

So they're about to set out with an A$800,000 mortgage.

This is where we enter...

The Ghost of Christmas Present

Looking online most of the current variable interest rate packages are around 4.55% for owner occupiers.

So at A$800,000 our couple are looking at repayments (interest and principle) of A$4,078 per month and an annual bill of A$48,936.

What does this mean? Well with their after-tax income of A$124,906 it means their mortgage repayments are roughly 39% of this amount.

It also means our couple has around A$1,460 per week (A$75,970 per annum) disposable income to spend.

Our couple is spending a lot on their mortgage compared to other OECD countries, however, they're pretty much in line with a lot of the larger sought after metropolitan cities globally.

Things are tight but ok.

The Ghost of Christmas Future

How high could interest rates go to by the peak of the next cycle?

It's impossible to predict 100% however if you look at the stress testing APRA and the RBA conduct it's possible to see home loan rates at around 7-8%.

So what would our couple's mortgage look like in two (2) years time at this rate?

Let's say that our couple has been consciousness and they've even paid a little extra and so the loan balance is now sitting at A$750,000.

Unfortunately for our couple interest rates have been steadily increasing and their lender is now charging 7.55% per annum on their variable loan.

So now our couple's repayments are A$63,240 per month (A$5,270 per month). At the current level of wage growth in two years time it's unlikely either of our couple have a raise. So let's assume their incomes are the same. This means their repayments are now just over 50% of their after-tax income.

It also means our couple now only has A$1,186 per week to spend (A$61,666).

How much do they need to tighten their belts by?

Around A$274 per week.

No small order. Takeaways, nights out and movies are off the table. Or it may just mean that that extra bit of saving that they've been doing at putting towards lowering their mortgage will stop and they'll just be making the minimum payments.

Ok, so what. They can still afford the mortgage!

Yes, that's correct. Our couple can still afford to pay the mortgage.

But there are three key issues here:

1. Interest rates. They'd need to peak at 7.55%. I've assumed that interest rates don't go up further. What if they did, things would get worse?
2. Spending. If you haven't been saving then you'll have to find some savings because genuinely there's A$274 per week less available. And if interest rates get even worse, our couple would have to cut out even more!
3. Jobs. This is always tough to imagine. You're great at your job. You love it. You do great work, your company is growing. Yes. In a bad economic climate, few employees are safe. In the Ghost of Christmas Future, remember the mortgage was now >50% of our couple's after-tax income. That means if one of the two earners loses their job, our couple is underwater from a serviceability standpoint. What then?

Lighten up!

I agree. It's not all doom and gloom.

Here are some common points back that I get often:

• I've bought somewhere cheaper I don't have that much borrowed.
• I fixed my interest rates they won't go up.
• My income is higher that the couple outlined above.

These are all very good points and I hope that they are the case. You'll only know how at risk you are if you take the time to sit down and do the math on your property.

Serviceability is just as important as price.