Borrowers face ‘king hit’ to budgets as fixed interest loans roll off

One of the first things you learn in economics is that all individuals face a “budget constraint”, under which they must balance their unlimited desires against their limited resources of both time and money.

When you boil it right down, economics is just the study of optimal human decision-making – both for individuals and for societies – under conditions of scarcity.

RBA governor Philip Lowe (inset). There are indications the RBA’s rate tightening is starting to have an impact beyond the housing market.
RBA governor Philip Lowe (inset). There are indications the RBA’s rate tightening is starting to have an impact beyond the housing market.Credit:Jason South, Louie Douvis

If time and money were limitless, the world would be entirely bereft of the need for any practitioners of this “dismal science”.

But life is short and so, increasingly, too, is money.

Indeed, with the cost of living rising at multi-decade highs and wages failing to keep pace, some of us – particularly owners of rather large mortgages – are about to become even more intimately acquainted with our budget constraints than we’d ever expected to be.

For many households juggling rising interest rates, it’s likely to be a bumpy transition.

Personally, I’m about as close to the classical model of “homo-economicus” – economist’s model of the perfectly rational human being who meticulously weighs the costs and benefits of each decision – as they come. I track – to the cent – all my income and expenditures each month and calculate my resulting budget surplus.

Then, I sit down to ponder if the “utility” – or happiness – I derived from each expenditure exceeded the dis-utility of having to work, rather than be at leisure, to earn the income needed to fund it.

I’m really fun at parties, too.

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Over the years, I’ve cut my cloth (and, on occasion, my own hair) to suit my increased desire for more leisure.

But even armed with this somewhat extreme budgeting discipline, I am beginning to feel a little nervous about impending interest rate rises. Goodness knows how the rest of you are coping.

Fortunately, my home loan is fixed until the middle of next year at 1.84 per cent. The downside, however, is that when my fixed interest rate expires and I roll onto a variable interest rate, I – like many other mortgage holders – am in for a fairly significant cash-flow shock.

Switching to even the lowest variable rate available today would mean I’d need to find an extra $600 per month. By Christmas, that’s likely to have risen to $900 a month.

The size of my budget surplus last month? $843. That is, without changes to my spending patterns, I’ll be in the red soon.

This isn’t a sob story – I have plenty of fat to cut. I can ditch my extra contributions to super of about $800 a month (although I will miss those sweet, sweet tax savings). Next on the chopping block could be my premium gym membership of $380 a month. I can also rein in my “eating out” budget, which blew out to $490 last month.

For variable borrowers, rate rises are already packing a punch.
For variable borrowers, rate rises are already packing a punch.Credit:Fairfax

I can easily make sacrifices to afford my loan. That’s largely because I didn’t borrow the maximum I was offered, and I was stress-tested at slightly higher interest rates than more recent borrowers.

Many others – particularly borrowers who ‘fudged’ their declared expenses when applying for loans – will soon be feeling the pinch.

It is something I hope our central bank policymakers are keeping front of mind as they adjust rates.

Aussie borrowers who shackle themselves to large mortgages also submit themselves – often unwittingly – to becoming part of the central bank’s “transmission mechanism of monetary policy”.

Changes in interest rates (also known as “monetary policy”) work in several ways to cool the economy, including through their impact on asset prices and the currency. But the “cash flow” channel is one of the strongest and what many borrowers are about to find themselves at the pointy end of – if they haven’t already.

Some will see their housing finances on a cliff edge.
Some will see their housing finances on a cliff edge.Credit:Fairfax

Compared with other countries, a higher proportion of Aussies home buyers tend to borrow via variable interest rates loans. This has always delivered our policymakers a unique advantage, because their manipulations of borrowing rates flow quickly through to household activity – either boosting or sapping spending power.

However, during the pandemic an unusually high proportion of Aussie borrowers took out loans on ultra-low fixed interest rate terms, which are set to expire over the coming one to four years.

For variable borrowers, rate rises are already packing a punch. But for many, the pain is being delayed and today’s rapid rate rises risk landing like a king hit to their budgets in years to come.

Many financially literate households are already trimming spending plans now, in advance of what has been dubbed a looming “fixed-rate cliff”.

Many less financially literate households, however, will only truly feel the shock when they actually roll off their fixed rate loans. There is a greater than usual risk of even sharper reductions in spending when they do.

For policymakers, it’s an added risk to the current economic outlook which needs to be given more weight.

For borrowers, there is little that can be done, other than to seek ways to either boost your income or cut spending.

We must all be economists now.

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Source: Thanks smh.com