Cash Rate Pass-through to Outstanding Mortgage Rates | Bulletin – April 2024 (2024)

Introduction

Monetary policy transmission occurs through several different channels. One of the most well-known is theeffect on household cash flows arising from the cost of debt servicing.^[1] This cash flow channel isparticularly evident through its impact on mortgage borrowers due to the high share of mortgage debt inAustralia, and especially because most mortgagors have variable-rate loans that are responsive to changesin policy rates (Kent 2023). Assessing the strength of this channel is therefore important forunderstanding how monetary policy is transmitting to the broader economy. At the same time, however,there are positive cash flow benefits to those with savings when interest rates rise, and higher interestrates provide an incentive for both borrowers and savers to save more than they otherwise would.

The RBA raised the cash rate target by 425basis points between May 2022 and December 2023.^[2] Overthis period, the average outstanding mortgage rate increased by around 320basis points. This wasaround 105basis points less than the cumulative increase in the cash rate. Hence, around75percent of the increase in the cash rate had passed through to the average outstandingmortgage rate, compared with nearly 90percent over the course of earlier tightening episodesin 2006 and 2009 (Table1; Graph1).

This article explores two developments that have slowed the pass-through of cash rate increases to theaverage outstanding mortgage rate between May 2022 and December 2023:

1. A high share of outstanding fixed-rate loans has contributed to slower pass-through compared withearlier tightening episodes in 2006 and 2009.
2. Outstanding variable rates have increased by less than the cash rate, alongside heightenedcompetition between mortgage lenders.

The average outstanding mortgage rate is projected to increase further as the remaining loans on lowfixed rates expire and reprice at much higher interest rates. As this plays out, cash ratepass-through to the outstanding mortgage rate is expected to reach a similar proportion to that seenin previous tightening episodes.

The effect of fixed-rate borrowing on pass-through

Many borrowers took advantage of the low fixed rates on offer during the COVID-19 pandemic to lock in their mortgage repayments for a period. The verylow fixed rates on offer reflected lenders’ access to options to fund such products at low ratesgiven the monetary policy settings at the time. Of particular note, unconventional policies implementedby the RBA, such as the Term Funding Facility and the yield target on the three-year AustralianGovernment bond, supported lenders in obtaining low-cost term funding (RBA 2023a). These factors enabledlenders to price their fixed rates below the variable rates that were advertised to new borrowers (RBA2023b). As a result, the share of fixed-rate housing loans increased substantially, from around20percent of outstanding housing credit in early 2020 to a peak of almost40percent in early 2022 (Graph2). This share has since declined to around17percent as of December 2023, reflecting the expiry of a significant proportion offixed-rate loans and the very low share of new loans on fixed-rates.

A little more than half of loans taken out at low fixed rates during the pandemic expired in 2023.^[3] The paceof fixed-rate expiries was particularly elevated over the second half of 2023; fixed-rate loan expiriesover the September and December quarters of 2023 each accounted for around 15percent offixed-rate loans outstanding as of December 2022. The bulk of borrowers who have rolled off fixed rateshave managed the transition to higher interest rates well (RBA 2023c). Most of these borrowers took outloans at low fixed rates of around 2–2½percent during thepandemic. These fixed-rate loans have, on average, rolled-off onto interest rates close to theoutstanding variable rate (Lovicu et al 2023). Based on prevailing mortgage rates as ofDecember 2023, expiring fixed-rate loans have repriced to an average mortgage rate of around6½percent.

While the pace of fixed-rate loan expiries has slowed, there remains a substantial share of low-ratefixed-rate loans – around 35percent of the stock of fixed-rate loans that wasoutstanding in December 2022 – that will expire over 2024. This will contribute to a furtherincrease in the average outstanding mortgage rate as these fixed-rate borrowers transition to much higherprevailing interest rates than they are currently paying. Under the assumption that these fixed-rateloans reprice to the current outstanding variable rate, the average outstanding mortgage rate isprojected to increase by an additional 35basis points between December 2023 and December 2024(Graph3). Slightly more of this increase would occur over the first half of 2024 as the pace offixed-rate loan expiries remains more elevated over this period compared with the second half of theyear. Such an outcome would ultimately result in a similar degree of overall pass-through to outstandingmortgage rates as observed in the previous two tightening episodes in 2006 and 2009, albeit over a longerperiod beyond the tightening phase.

By contrast with the most recent episode, fixed-rate loan expiries over the 2009 tightening episodelimited the pass-through to outstanding mortgage rates. This is because most borrowers thattook out fixed-rate loans prior to the 2009 tightening episode had fixed rates that were higher than theprevailing interest rates at the time when these fixed-rate loans expired.^[4] Thesefixed-rate borrowers transitioned from higher fixed rates to lower prevailing rates, which meant thatthese expiries contributed to a lower, rather than a higher, average outstanding mortgage rate.

Another factor affecting pass-through is the share of new fixed-rate lending that takes place during the tightening phase. While few borrowers have taken out fixed rates over the current tighteningepisode, fixed-rate loans accounted for a material share of new lending over the 2006 tightening episode.The outstanding share of fixed-rate loans increased from around 20percent in May 2006 toaround 30percent by the middle of 2008 (Graph4). Fixed rates also tracked variablerates more closely over the course of the 2006 tightening phase relative to other episodes. Borrowersthat took out fixed-rate loans during the tightening phase therefore experienced a smaller increase intheir mortgage rates, as they did not incur the full increase in mortgage rates over the tighteningperiod. This, in turn, limited the extent of pass-through to the total outstanding mortgage rate over the2006 tightening episode.

The effect of funding conditions and mortgage lending competition on pass-through

The recent period of heightened mortgage lending competition – particularly over the second half of2022 and early 2023 – has contributed to the average mortgage rate paid on outstandingvariable-rate loans increasing by around 75basis points less than the cash rate between May 2022and December 2023 (Graph5). Since the start of cash rate tightening, many borrowers have sought outlower mortgage rates by negotiating with their existing lender or by refinancing with another lender. Atthe same time, lenders have been more willing to accommodate requests to lower existing mortgage rates,particularly to retain good quality borrowers. The average rate on new variable rate loansincreased by around 40basis points less than the cash rate between May 2022 and December 2023, aslenders offered mortgage rates at lower spreads to the cash rate to attract new borrowers.

Lending competition for variable-rate mortgages increased over the second half of 2022 as a sustainedwillingness by banks to compete for mortgage loans at the time coincided with a slowing in housing creditgrowth. At the same time, banks had access to cheap and abundant funding, including deposits. Depositfunding from households and businesses grew strongly during the pandemic, which contributed to a moresubdued increase in banks’ overall funding costs than would have otherwise been the case (ACCC2023). The interest rate paid on at-call deposits, which makes up around 65percent of alldeposits, increased by around 160basis points less than the cash rate from May 2022 to December2023 (Graph6). These lower funding costs allowed banks to offer more competitive pricing,especially at the start of the current tightening episode. This was particularly the case when comparedwith non-bank lenders with no access to deposit funding.

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Heightened lending competition was evident in lenders offering cashback deals of between $2,000and$5,000to attract both new and refinancing borrowers. Lenders also increased the discounts offeredon their advertised variable lending rates (relative to benchmark standard variable rates). The averageincrease in discounts on these advertised rates peaked at around 35basis points around the start of2023 (Graph7). These measures provided an incentive for many existing borrowers to seek out a lowermortgage rate by negotiating with their existing lender or by refinancing externally.

Signs of easing competition have emerged since the start of 2023. Most lenders withdrew their cashbackoffers in the first half of 2023 and reduced the discounts offered on their advertised variable lendingrates. While the average variable rate on new loans increased by slightly more than the cash rate oversome periods, the cumulative increase in the average new variable rate over the current tightening phasewas still around 40basis points less than the cash rate as at December 2023 (RBA 2023b). Despitesome signs of easing competition, many lenders have generally remained willing to negotiate discounts toretain existing borrowers. External refinancing activity has also remained at elevated levels afterincreasing sharply over the second half of 2022 (Graph8).

Over the most recent tightening episode, banks’ average funding costs have increased by a little lessthan the cash rate (De Zoysa, Dunphy and Schwartz 2024; Carse, Faferko and Fitzpatrick 2023). Bycomparison, tighter funding conditions emerged during the 2006 and 2009 tightening phases due toincreased volatility in financial markets and a structural shift in demand by the banks for more stablefunding sources such as deposits and long-term wholesale funding.^[5] Higher funding costs weresubsequently passed through to existing borrowers and resulted in the average mortgage rate onoutstanding variable-rate loans increasing by more than the cash rate during these earlier tighteningepisodes (Graph9). Lenders passed through these costs to their variable-rate borrowers in additionto passing through the increases in the cash rate. As a result, variable rates increased by more than thecash rate in the latter stages of the tightening phases in 2006 and 2009, leading to more pass-through tothe overall outstanding mortgage rate.

Pass-through from mortgage rates to total scheduled mortgage payments

Despite slower pass-through to outstanding mortgage rates over the current tightening episode, the flowthrough of a higher cash rate to housing mortgage rates has still been an effective transmission channelfor monetary policy in Australia. The relatively high share of variable-rate mortgages in Australia hasmeant that the average outstanding mortgage rate had increased by more than in other developed peereconomies such as the United States, New Zealand and Canada as of December 2023, despite a smallerincrease in policy rates in Australia (Graph10; Kent 2023).^[6] Housing mortgage payments haveincreased considerably as a share of household disposable income, even though slower pass-through tomortgage rates than previous cycles has meant that the aggregate repayment burden faced by mortgagors has– so far – increased by less than otherwise.^[7]

Total scheduled household mortgage payments (comprising both interest and scheduled principal payments)have increased to around 10percent of household disposable income as of December 2023,exceeding the estimated previous historical peak in 2008 (Graph11). These scheduled mortgagepayments are expected to increase further to reach around 10½percent of household disposableincome by end-2024 as more fixed-rate loans expire and reprice at higher interest rates. While thissuggests a significant increase in household mortgage payments over the current tightening phase, thisarticle does not consider other forms of household debt such as personal or small business loans. Theseforms of household debt also affect households’ cash flows, although they account for a much lowershare of household income compared with a decade prior (Kohler 2020).^[8]

Conclusion

The increase in the average outstanding mortgage rate relative to the cash rate has been slower over thecurrent tightening episode than in some previous tightening phases. This has been due to the high shareof loans at very low fixed rates taken out during the pandemic and the effect of elevated mortgagelending competition on variable-rate mortgages. The average outstanding mortgage rate relative to thecash rate is expected to increase further as more fixed-rate loans expire. As a result, the extent ofpass-through by the end of 2024 is anticipated to be similar to previous tightening episodes.