Bank competition, the incomplete pass-through of the cash rate & loan payments

One channel of monetary policy that receives outsized attention in Australia is the effect of higher interest rates on the cash flow of households, where loan payments are still up sharply despite mortgage rates rising by less than the cash rate, albeit with little stress so far in that households are still making additional payments on their mortgages. 

The incomplete pass-through of the higher cash rate to lending rates is clear from RBA data on the average interest rates paid on all new and existing mortgages. 

The data, which have a short history and are published with a lag, show that, as at March, the cash rate was 350bp higher than last year’s near-zero trough, with the average interest rate on all new home loans up about 290bp and the average rate on existing mortgages up about 225bp.

The smaller pass-through of the cash rate to the interest rate paid on existing mortgages is not surprising given that it mainly reflects the unprecedented surge in fixed-rate loans at the height of the pandemic when borrowers locked in ultra-low rates. 

These fixed rate mortgages started rolling off last year and by next year the interest rate paid on existing mortgages will broadly catch up with the prevailing increase in variable mortgage rates given hardly anyone is fixing their mortgage nowadays.

In that respect, the incomplete pass-through to variable mortgage rates, which have lagged the increase in the cash rate by about 50bp, is more important. 

If this gap is sustained, it would contrast with the past few rate hike cycles, where variable mortgage rates rose by at least the increase in the cash rate and usually by slightly more. 

It would instead hark back to the rate hike cycles of the 1980s and 1990s when variable rates rose by much less than the cash rate.

In our view, the incomplete pass-through likely reflects intense competition between the major banks to write new loans in a more difficult housing market. 

This is seen in new home loans slumping to around 11% of GDP, almost matching the lows reached immediately prior to the pandemic, which themselves were the lowest levels of lending in a couple of decades. 

That said, competition may have peaked for the time being given that new home loans picked up in March for the first time in over a year.

Even with the incomplete pass-through of the cash rate to date, there has been a substantial increase in loan payments given households remain highly geared after leveraging up in the 1990s and 2000s. 

Payments on all loans – i.e., mortgages, consumer loans and small business debt – have increased from about 11% of household income a year ago to an estimated 14% in Q1.

Assuming that the cash rate rises above 4%, payments could reach about 17% of income, nearing the all-time high of 19% reached in the middle of the global financial crisis in 2008.

At this stage, though, many households appear to be holding up well in the face of higher interest rates in that there was an increase in unscheduled mortgage payments in Q1. 

Extra mortgage payments reached 4-5% of income during the pandemic on the back of record government financial assistance and the lowest mortgage rates in decades, before falling to less than 2% of income at the end of last year. 

However, in Q1, excess payments rose to around 2% of income, which matches the average rate in the years prior to the pandemic.