It's going to be a nervous Christmas for many Australian home owners as BBQ conversations turn to the consequences of owing more on the family home than it's worth

There’ll be a new, and unwelcome, topic of conversation at many family gatherings in Australia this Christmas – ‘negative equity’. That once unthinkable situation where the size of a person’s mortgage exceeds the value of their home.

Sadly, negative equity is now emerging as a real prospect for many Australians who purchased their homes in the last twelve months. 

Their dilemma was exacerbated last week when the Reserve Bank of Australia (RBA) hiked the cash rate for the eighth time since May. The rate has now risen this year from a low of 0.1% to a decade high 3.1%.

The only good news is that the board of the RBA doesn’t meet in January, giving borrowers a brief reprieve.

According to Graham Cooke, head of consumer research at Finder, the latest RBA hike means that “the average home loan rate has jumped from the mid-3s to the mid-6s”. Cooke says that to “comfortably afford” a $500,000 mortgage will now require a minimum income of  $180,000. The comparative figure back in April was just $121,000.

And three of the four big banks are predicting that the RBA will increase the cash rate next year by at least another 0.5%. That would mean interest rates on many home loans starting with a 7, a level unimaginable to first home buyers in recent years.

Many Australian home loans start with a fixed interest rate and then after a pre-determined period (usually 1-3 years) convert to a variable rate. The gap between some of those historical fixed rates and current variable rates has now blown out dramatically. That spells trouble for many borrowers when their loan converts.

During 2021, the initial fixed interest rate on home loans dropped to as low as 1.95%. It’s not difficult to imagine the consequences for borrowers when their interest rate jumps from less than 2% to more than 6%.

For some borrowers, the jump will be unsustainable.

It’s estimated that $370 billion worth of Australian housing loans will convert from fixed to variable during 2023. Inevitably, the accompanying rise in servicing costs will create widespread mortgage stress.

Some homeowners faced with a spike in their interest rate will look to reduce their outgoings by refinancing their debt at a lower interest rate with an alternative lender. There’s often scope to do that given the competitive market for home lending.

However, a large proportion of the loans moving from fixed to variable interest rates in 2023 will be owed by people who purchased homes at or near the top of the over-heated post-pandemic property market. They will have lost some or all of their equity, making it impossible for them to refinance. In other words, many of those worst affected by rising interest rates will be least able to do anything to ease their predicament.

The obvious danger is that some will be forced to sell their homes, thereby putting more downward pressure on house prices and leaving more people in negative equity. Potentially a vicious circle of distressed sellers driving house prices down leading to yet more distressed sellers.

The fate in 2023 of many recent home buyers will depend on a range of factors, the key ones being house prices, interest rates, and the rate of unemployment.

The outlook for house prices is not promising. As we head into Christmas, prices are in decline in most parts of Australia. CoreLogic’s ‘National home value index’ was down for the seventh month in a row in November.

Prices in the Australian capital cities fell 3.5% in the three months to the end of November. In Sydney, the drop was 4.4%, taking the total slump from the January peak to 11.4%. In Brisbane, where prices started falling later than in Sydney and Melbourne, there was a drop of 5.6% in just the last three months.

In some places the pace of decline has slowed. However, CoreLogic Head of Research Eliza Owen warns that “there is still a risk of the decline re-accelerating in the year ahead”.

Christopher Joye, writing in the Australian Financial Review, adopts a more bearish perspective – “The most constructive thing we can say is that house prices are falling incredibly quickly, albeit at a slightly slower pace than what was recorded a few months ago”.

In some areas the drop has already been severe. According to CoreLogic, over the last twelve months houses in Narrabeen on Sydney’s northern beaches, and in Surry Hills in inner Sydney, have plunged 26.8% and 25.4% respectively.  Units in Sydney’s Centennial Park and Mona Vale are down more than 20%.

Falls of that magnitude make negative equity inevitable for many recent buyers.

It’s difficult to envisage a change in the direction of house prices until there is more certainty around interest rates. For the moment at least, the expectation in most quarters is that rates have further to rise.

In his media release last week, RBA governor Philip Lowe stated that “the Board expects to increase interest rates further over the period ahead, but it is not on a pre-set course”. Ominously for homeowners, particularly new ones, the Board “remains resolute in its determination” to bring inflation back within the RBA’s target range of 2 to 3%. It’s currently around 7%.

It takes some time before RBA rate rises are felt by borrowers. According to the Commonwealth Bank of Australia, the country’s largest home lender, “from a cash flow perspective the impact is not felt for three months on average for a CBA customer”.

This means that the cashflow of CBA variable rate customers has yet to be affected by the RBA’s last three rate rises. It follows that the pain from those rises has not yet been fully factored into house prices.

Add that delay to the anticipated additional rate rises next year, plus the conversion of $370 billion of mortgages from fixed to variable, and a challenging picture emerges for the housing market.

It’s going to be a nervous Christmas for many recent home buyers.

Ross Stitt is a freelance writer with a PhD in political science. He is a New Zealander based in Sydney. His articles are part of our 'Understanding Australia' series.