Dangerous heights: Interest rate peak poses big risk

The ASB economists warn the OCR peak could turn out to be higher than expected. Photo / Getty Images

Rises could see first-home buyers spend bulk of income on mortgage, economists say.

Interest rates could peak at a level which would see first-home buyers in Auckland spending two-thirds of household income paying the mortgage, or even more, ASB economists say.

They forecast the peak for the official cash rate in the tightening cycle the Reserve Bank embarked on last month to be around 4.5 per cent - the level they and the Reserve Bank regard as roughly neutral, neither stimulating nor restraining the economy.

But household debt levels are high by historical standards at around 147 per cent of household disposable income, up from around 100 per cent in 2000. These are aggregates for the household sector as a whole; for many individual households the ratio would be much higher.

"While the overall debt burden has remained very high, debt servicing costs have been low thanks to low interest rates. But, because of the size of that debt burden, servicing costs relative to income will rise quickly as interest rates climb," the ASB economists say. For new home buyers, affordability could quickly become stretched, especially in Auckland, they warn.

If the OCR were to rise to 4.5 per cent by the end of next year, repayments on a newly-bought home would rise from the current 37 per cent of disposable (or after-tax) income to 45 per cent at the national level. That is for a household earning the median income and paying the median price with a 20 per cent deposit and a floating mortgage rate.

"In Auckland, where we assume stronger house price growth, the combined impact of price and interest rate increases would push repayments up from 52 per cent to 67 per cent. In the previous cycle, the peak in repayments was 56 per cent at the national level and 70 per cent in Auckland. So, from a housing affordability perspective, an OCR of 4.5 per cent would likely take conditions in Auckland back to a similar state as was seen at the peak of the previous tightening cycle."

Although they expect a lower track for the OCR than in the 2000s, when it peaked at 8.25 per cent, since the global financial crisis there has been a substantially wider spread or risk margin between the benchmark interest rates and banks' actual funding costs.

The ASB economists warn the OCR peak could turn out to be higher than they are currently picking, however.

The neutral rate may be higher than 4.5 per cent if borrowing appetites rebound back towards the levels prevailing before the GFC.

And it may be necessary for the Reserve Bank to push the rate beyond neutral if inflation threatened to stay above its target of 2 per cent over the medium-term.

On the same assumptions, if interest rates were to be an extra 1 percentage point higher by the end of next year, first-home buyers' mortgage bills would rise to 49 per cent of income nationally and 72 per cent in Auckland.

"An OCR of 4.5 per cent will increase existing mortgage holders' debt servicing costs moderately. However, the impact on the affordability of new house buyers will be quite pronounced and effective in containing house prices and the flow-on effects from the housing market to inflation."