Would you like to take out a home loan where the bank can’t change the interest rate for 30 years? Americans can lock in their mortgage rates for decades, but that’s not necessarily as good as it sounds.
When the Great Depression hit nearly a century ago, the US started pivoting away from variable rate home loans towards fixed rate loans. Variable rates can change based on market interest rates, whereas fixed rates remain the same over the life of the loan. The president at the time, Franklin D. Roosevelt, wanted to make homeownership more affordable.
Americans can lock in their mortgage rates for decades.Credit: Louise Kennerley
Today, variable rate mortgages are a rare sight in the US, accounting for less than 5 per cent of home loans. By contrast, roughly 70 per cent of mortgages in Australia are variable rate loans, coming second in proportion only to Norway.
How did this happen? And do US households and their economy have it better?
As part of the New Deal in the 1930s, Roosevelt launched the Home Owners’ Loan Corporation to buy and convert failing mortgages into longer-term loans, and a Federal Housing Administration (FHA) to insure home loans against default and set new lending standards. These things helped bring about the 15-year mortgage, which the FHA gradually pushed out to 30 years.
Predictable payments over a longer period made homeownership more affordable for buyers, but a fixed rate over 30 years didn’t make much sense for the banks. That’s because banks needed to fund themselves, too, borrowing at interest rates which were not fixed. If their own borrowing costs increased, while their customers’ interest rates stayed the same, it would risk the banks losing money.
So, in the 1970s, the US Congress gave the green light for government-sponsored enterprises Fannie Mae and Freddie Mac to buy mortgages from lenders, shifting the risk off the banks’ books. This made 30-year fixed loans more attractive for lenders as well as home buyers.
It was around the 1980s that Australian financial institutions began offering fixed-rate loans. But they never really ended up taking off. That’s partly because Australia has never had its own equivalent of Freddie and Fannie. Instead, we have a handful of private firms which securitise a small portion of our mortgages, meaning the banks have to bear the brunt of the risk if they choose to lend at fixed rates.
The upshot of this is that fixed-rate mortgages are much less common in Australia, and are usually for only one to five years at most.
There was a period during the COVID-19 pandemic, when the value of fixed-rate home loans in Australia peaked at nearly 40 per cent of outstanding housing credit – roughly double the share before 2020. But this was the result of unprecedented cut-throat competition between the banks, which ended up becoming unprofitable for many of them.
Predictable payments over a longer period made homeownership more affordable for buyers, but a fixed rate over 30 years didn’t make much sense for the banks.
As most Australians’ fixed-rate terms, locked in during the pandemic, came to an end, Australia’s proportion of fixed-rate loans fell back to lower levels. By mid-2022, the share of fixed-rate loans had dropped to about 20 per cent.
While Australians, on the back of 13 rate rises in two years, may be enviously eyeing Americans’ fixed-rate mortgages, it’s not all a rosy picture for US mortgage holders either.
Fixed-rate home loan holders in the US can refinance their 30-year fixed mortgages when rates drop. So they benefit if rates go down and are shielded when rates increase. But there is a refinancing cost of between 2 and 6 per cent of the loan amount, which can make switching an expensive exercise if rates go down.
When interest rates are rising, it might seem like Aussie households with variable-rate mortgages get the short end of the stick.
Reserve Bank of Australia assistant governor Chris Kent.Credit: Brent Lewin
But the popularity of variable-rate mortgages in Australia is part of what makes the Reserve Bank more agile than many central banks around the world when steering the economy.
It comes down to what’s called the “cash flow” mechanism which, as Reserve Bank assistant governor Dr Chris Kent explained in a speech last year, is one of five ways the bank’s monetary policy decisions flow through to us. It’s where, as interest rates go up, households and businesses pay more on their debt and earn more on their savings (and vice versa when rates go down), affecting their ability to spend on consumer goods and services.
Recently, policymakers have aimed to dampen our rate of spending – our economic activity – and thereby reduce the upward pressure on prices.
While the elected government mostly tries to change our behaviour through enacting laws, taxes, and tightening or loosening its purse strings on government funding, the Reserve Bank’s main tool – as discussed last week – is monetary policy: It declares a cash rate target which then influences the interest rates set by our commercial banks, and ultimately the rates we pay on our loans and receive on our bank deposits.
Australian mortgage holders are especially sensitive to rate changes because most are on variable rates. That means their mortgage rate bounces up and down, usually in lock-step with the interest rates set by the Reserve Bank. When the Reserve Bank’s cash rate target goes up, we usually see big four banks follow suit with very similar increases in their mortgage rates.
In some other economies, such as the US, it takes much longer for a central bank’s decisions to flow through to mortgage rates because so little of US mortgages rates are variable. It’s probably part of the reason interest rates in the US had to be ramped up more by the Federal Reserve than by the Reserve Bank in Australia: because only a small proportion of households felt the effect.
Every time the Reserve Bank changes interest rates, the effect is close to immediate. If passed on fully by the banks, interest rate increases since May 2022 would have added about $1561 in monthly repayments on an average $600,000 home loan.
That money has to come out of somewhere. Households have to save less each week, draw down on their past savings or spend less so as to cover their higher monthly repayments. That’s exactly how the Reserve Bank’s “cash flow” mechanism is supposed to work: it reduces or increases the amount households can spend on other things in the economy, either stimulating or slowing down demand for goods and services, and economic activity.
Since Australian households are among the most indebted in the world (coming second only to Switzerland in 2022), changes in the interest rate have not only a quick flow-through, but a big impact.
Households with savings might benefit from earning more interest, and therefore spend more. But those with savings tend to spend less of every extra dollar they earn. And the amount of Australian household debt is greater than our stock of savings, meaning the 4.25 percentage point increase in the cash rate target since May 2022 has had the overall effect of dampening household spending by about 0.4 per cent to 0.8 per cent a year through the cash flow “channel” alone.
The speed and extent to which the cash flow mechanism kicks in here means that whether the Australian economy needs a jumpstart, such as during the pandemic, or a cool down in activity and inflation, the Reserve Bank can have a large and immediate impact. It may feel painful for households when rates are rising, and the RBA must be careful not to go too far, but our attachment to variable rates does come with benefits.
Ross Gittins is on leave.
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