Rising interest rates will over time reduce demand & send house prices lower: RBA

Want to know exactly how sensitive housing prices are to interest rates? Well, the Reserve Bank of Australia’s (RBA) Head of Domestic Markets Jonathan Kearns may have some clues.

Kearns recently advised a Sydney business conference how the 225-point interest rate rise since May has affected the housing market.

Kearns believes rising interest rates will "over time" reduce the demand for housing, sending prices lower to benefit new borrowers.

Sensitivity to interest rates

Despite considerable uncertainty over how and when interest rates will temper residential and commercial property prices, in April, the RBA noted within its Financial Stability Review that a 2-percentage point increase in interest rates would lower inflation-adjusted house prices by about 15% over a two-year period.

But given the impact of other factors such as incomes, population, and household preferences, Kearns reminded the market that these figure were by no means a forecast.

“… it was an estimate of how sensitive housing prices are to interest rates, assuming that all the other costs and benefits to housing don’t change with interest rates,” Kearns added.

Declines after two years

The net effect adds Kearns is that mortgage payments for new buyers would be higher for around two years, courtesy of higher interest rates, but after that, he expects declines in housing prices and mortgage size begin to dominate.

"… because higher interest rates reduce housing prices and so mortgage sizes, mortgage payments for new borrowers could ultimately be lower than if interest rates had not increased."

Kearns also reminded investors that properties in places within what he descried as ‘inflexible’ housing supply, high levels of mortgage debt, more investors and higher incomes were more vulnerable to an interest rate-driven property price downturn.

Smaller loans

While the 225-point increase in the cash rate - fully passed through to mortgage interest rates since May – has likely reduced borrowers’ maximum loan size by about 20%, Kearns notes most home buyers do not take out the maximum size loan available.

Recent reporting by banks suggest only around 10% of borrowers take out a loan close to their maximum possible size.

"Even if all borrowers’ maximum loan size is reduced by 20% in response to higher interest rates, not all new borrowers will have to take out a loan that is 20% smaller," Kearns noted.

Elevated prices matter

To help put the duration of elevated prices in context, Kearns notes if interest rates increased by 2 percentage points, only to revert to their initial level after a couple of years, the dampening effect on prices would unwind.

However, Kearns adds if rates were permanently 2 percentage points higher, prices would fall by around 30%.

While RBA has lifted rates by 2.25 percentage points since May, the market now expects the cash rate to reach 3.3% by the end of the year, before peaking at 3.9% in April next year.