Why Mortgage Rates Could Tip to 7% Very Soon?

Karl Hilzinger

BURDEN: Floating interest rates could top 7 per cent by the end of next year.

Home buyers and farmers appear likely to bear the brunt of new mortgage lending requirements which could start to take effect by the end of this year and potentially push mortgage interest rates above 7 per cent by the end of next year.

One of the ways the Reserve Bank is considering reining in what it sees as risky lending by banks is by introducing what it calls Sectoral Capital Overlays (SCRs). These would require banks to increase the amount of capital they hold, relative to the nature and scale of their lending into specific sectors of the economy.

Although the requirement could be applied to any economic sector, it is probably significant that the only sectors referred to as potential candidates for the treatment in the Reserve Bank's policy statement on the subject were agriculture and housing.

While the pace of growth in residential mortgage debt captures most of the headlines, the latest figures from the Reserve Bank show rural debt has been ballooning at an even faster pace.

They show that farm debt to banks and other financial institutions was $50.4 billion at the end of March and increasing at an annual rate of 5.2 per cent.

Although household debt, which is mostly made up of mortgage lending, was higher overall at $193.6b, it was growing at a slightly slower pace, 4.3 per cent a year.

By comparison, loans to businesses ($78.9b at the end of March) were growing at just 1.9 per cent a year and that rate of growth had been in decline since October last year.

The Reserve Bank's policy statement on SCRs said introducing them could make the targeted sectors, such as housing and farming, less attractive for the banks to lend to.

"Banks might decide to reduce their exposures to the sector if faced with a higher cost of funding. Alternatively, should banks pass on any increased funding cost, a rise in borrowing costs would help reduce demand for credit in the targeted sector," it said.

It may also moderate rising house or farm prices.

"Expectations of slower credit growth may flow through to asset price expectations, helping mitigate speculative demand," the statement said.

The likely implications for borrowers are that riskier loans, such as those where the borrower has a low amount of equity, will become harder to get and interest rates may start to rise.

While introducing SCRs is only one of the tools the Reserve Bank is looking at using to control residential mortgage lending in particular, there is a growing feeling that it will need to raise interest rates as well, to take some of the heat out of the housing market, and possibly the rural property market.

Mortgage interest rates are at their lowest level since 1964 (refer graph) so, given the cyclical nature of financial markets, it's likely they will start to rise. The big question is when.

Dr Ganesh Nana, chief economist at economic consultancy BERL, believes there is a case to be made for lowering interest rates further but conceded they are more likely to rise than fall.

In separate reports released last week, Institute of Economic Research principal economist Shamubeel Eaqub and BNZ chief economist Tony Alexander both picked that the Reserve Bank would start forcing up interest rates some time next year.

Eaqub believes that could happen as soon as January, and that the Reserve Bank will likely have raised interest rates by 1.25 per cent by the end of next year, which would push most mortgage interest rates to above 7 per cent.

But in doing that the Reserve Bank would be treading a fine line.

The effect higher interest rates would have on mortgage repayments can be seen in the accompanying table, but their overall effect would be broader than that.

According to the Reserve Bank, the household, business and agricultural sectors collectively owed banks and finance companies $322.8 billion at the end of March, and that mountain of debt grows higher each month.

Every 1 per cent rise in interest rates would add another $3.23b a year to the interest payments made by households, farms and businesses to service that debt.

On the other side of the coin, people have been pouring money into bank deposits in spite of the low interest rates they have been providing. At the end of March, banks and other savings account providers were sitting on $117.9b in depositors' funds.

So every 1 per cent rise in deposit rates would plough another $1.18b (before tax) back to those account holders.

If deposit and borrowing rates both increased by 1 per cent, the net cost to the economy would still be more than $2b a year, putting at risk the fragile economic recovery.

A bigger worry for the Reserve Bank would be that higher interest rates could push up the value of the New Zealand dollar at a time when the bank is trying to force it down. So it has the formidable task of trying to bring down the exchange rate while cooling the overheated housing and possibly the rural property market at the same time.

A lower exchange rate would boost export earnings, but also raise the cost of imported goods.

This means that heading into next year, anyone with a mortgage could be facing the twin perils of rising interest rates, which would force up their mortgage payments, and higher prices for imported goods, which would include everything from petrol to computers, clothing, tea and coffee.

While there is considerable uncertainty about the extent and timing of those events, one thing seems certain.

The currently favourable environment (for household borrowers) of low interest rates and the low cost of imported goods is unlikely to last much longer.

Anyone considering taking out a home loan or other form of debt should, therefore, leave themselves some wriggle room to cope with potentially higher costs hitting their household budget in the next year or so.