As the year draws to a close, Kiwibank chief economist Jarrod Kerr provides a snapshot on mortgage rates, household debt and inflation.

• The cost of living crisis has worsened for those with debt. Most mortgage holders have rolled off the record low rates from 2021. The 2% rates were great while they lasted. But the pain is intensifying, with rates above 7%. 
• The first tranche of refixing last year hurt. One-year rates from 2021 doubled in 2022. And our economy contracted. Now, the two-year rates fixed two years ago are rolling off. And our economy may contract again. It’s by RBNZ design. But it hurts. 
• On the other hand, savers are getting more bang for their buck. Term Deposits are the highest since the GFC.

We hear a lot about the cost of living crisis. The cost of everything we buy has risen sharply, and much more than our incomes. The cost of living crisis is hitting poorer households much harder than the rich. It’s not equitable, and inequality is getting worse. Lower income households are spending a lot more of their incomes on essentials, are forced to spend less elsewhere, and they’re getting a lot less for every dollar spent. We are also seeing an increasingly squeezed middle. Interest rates have risen rapidly and anyone with debt is facing much, much higher interest repayments. And it hurts. New entrants to the property market are facing interest rates 2-3 times higher than a year or so ago. Their cost of living is increasing faster and higher and it’s tightening the squeeze. 

Mortgage rates have risen a lot over the last two years. From the depths of the Covid response, a record low cash rate of just 0.25% (with talk of negative rates) meant mortgage rates were slashed to 2-to-3%. Mortgage holders took these rates and enjoyed a record reduction in interest deduction. 

But alas, the last of the record low mortgage rates are now rolling off. About 10% of mortgages are on floating rates, with around half on fixed rates for one-year and under, and a quarter fixed for two-years. The important point here is that it takes up to two years for previous interest rate hikes to fully feed through the system. The 525bps of RBNZ tightening, taking the cash rate from 0.25% in 2021 to 5.5% today, is still feeding through for some.

The rapid rise in the RBNZ’s cash rate has seen mortgage rates jolted from the record low two’s to now mid seven’s and even eight’s. The average share of disposable income going to interest payments will double from less than 10% to over 20% by year end and continue higher into 2024. 

The end of cheap money

So far, signs of financial stress have been low. The number of arrears have increased over the past year, but they’re rising off historic lows. Current, and forecast, arrears remain below GFC levels. But we are expecting pockets of stress will emerge. Buyers made decisions on the rate they were given at the time in the mid two’s to three’s. They’re now rolling off onto rates of 7% and higher.

A lot hinges on the labour market. Low unemployment has supported households. But in a high interest rate environment, demand weakens, businesses pull back, and unemployment rises. We’re seeing that already. 

The unemployment rate is expected to rise from the recent low of 3.2% to 5.5% late next year. Any increase in unemployment produces some distress. But a 5.5% peak would be considered a soft landing, as brutal as it is for those without work. Things would turn a lot uglier if we end up with +7% unemployment, as we start to see a more exponential rise in mortgage defaults.

The result of “higher for longer” monetary policy is simple. Indebted households must pay a much bigger proportion of their incomes on interest. Household budgets have already been stretched by the cost of living crisis and the rapid rise in the cost of essential items has forced households to spend less on discretionary items. The pullback in home contents and furnishings is a classic example. The average number of purchases is sitting ~5% below pre-Covid levels. We actually saw this restraint to splurge beginning a year ago, with non-essential goods and services continuing to remain under pressure. 

Households with debt are paying a lot more on interest repayments. And the main asset, to which the debt is tied, has fallen close to 20% in value. That’s a knock to confidence. We continue to forecast a mild contraction in activity, largely due to the stresses on households.

In order for money to be lent, money must be saved. We speak at length about the borrower, but often ignore the saver. Savers include retirees living off interest, cashed up businesses, first home buyers building a deposit, or a teenager saving for their OE. As interest rates were slashed to the record lows of 2021, savers were crying foul. Term deposit rates dropped below 1% over late 2020-2021. Many savers, especially retirees reliant on nest egg interest, came under pressure. Now, term deposit rates are the highest they have been since the GFC and savers are earning more. Savers can now receive 6% (or higher) on term deposits. Term deposit rates, for the first time in a long time, now exceed inflation (currently 5.6%, and headed lower into next year). We’re no longer hearing the cry of “foul” from savers. It’s now a little easier to live off savings, although we need to see inflation (the savings thief) back below 3% ASAP.

For the love of charts

We have a lot of household debt. And with larger debt burdens comes a greater sensitivity to interest rates. Debt-to-income has been relatively stable over the last decade but is much higher than the levels of the 1980s, 90s and early 2000s. A 7% interest rate today is a lot more impactful than a 7% rate 20 years ago.

Most mortgage lending goes to owner-occupiers.  The main development in mortgage lending has been the lift in first home buyers (FHBs). Whereas investors, under fire from the regulator and previous government, have retreated. The introduction of a longer brightline test, the removal of interest deductibility, changes to consumer credit access (CCCFA), and general market conditions have weighed on investor appetite. We may see a rebound in investor activity if the incoming government reverses, or at least partially reverses, these constraints. 

Interest-only lending has declined as a proportion of total lending. The growth in mortgage lending has been on P&I (principal and interest) terms. It’s safer, and households are injecting equity.

The mortgage rates offered in 2021 were the lowest ever recorded. People made investment decisions on these rates, nonetheless, and pain is being inflicted by the rapid rise in interest rates over 2022 and 2023.

It’s not all about housing. Banks lend to businesses as well. And the chart below highlights the higher risk and default rates in general business lending.  Lending in agriculture has seen the greater share of defaults over the last 15 years. Default rates are expected to rise the most, as costs climb (including interest costs) and commodity prices remain soft.

We are winning the inflation war

We have witnessed the most aggressive hiking cycle in the RBNZ’s history. All in response to the return of the inflation beast. While inflation remains high above the RBNZ’s 2% target midpoint, the distance is narrowing. Inflation is moving in the right direction. We are winning the war. But for the RBNZ to uphold its inflation-fighting credentials, interest rates will have to remain high and restrictive for some time yet. However, 15-year-high rates should be enough to see inflation back at the target 2%. No further tightening from the RBNZ is needed. Phase II will be a normalising in monetary policy. And we may see the rate cutting cycle commence next year.