Why It's Good News For The Battlers

Low inflation has placed home-ownership within the grasp of many more Australians, including those for whom it was once only a dream.

WE'RE due for some more good news on inflation today when we see the latest CPI figures, but it's not likely to raise much of a cheer. After all, what's so wonderful about low inflation? More than you may think. It's done wonders for the Great Australian Dream of home-ownership. And that's the biggest break the Aussie battler's had in ages.

The not-so-obvious links between inflation and housing were spelt out by Glenn Stevens, an assistant governor of the Reserve Bank, in a speech to the Real Estate Institute of Australia earlier this month.

Mr Stevens reminds us that the annual inflation rate averaged 10 per cent in the 1970s and more than 8 per cent in the 1980s.

It was a factor that made it much harder for people on modest incomes to afford a home loan. Had it persisted, it threatened to bring down Australia's high rate of home-ownership.

In the 1990s, however, the inflation rate has averaged only about 2.5 per cent. This fall has made it much easier for people on modest incomes to afford a home loan. In the process, it has removed the threat to the continuation of the Great Australian Dream.

The rate of inflation obviously affects the rate at which the price of homes rises, but its greater affect on the affordability of home-ownership comes via its effect on the level of mortgage interest rates.

Lower inflation leads to lower interest rates. Why? Because lenders demand an interest rate that not only rewards them for giving you the (temporary) use of their money, but also compensates them for the loss in the purchasing power of their money while it's in your hands.

With help from increased competition in the home-lending market, our return to low inflation has cut the interest rate on standard variable-rate mortgages to 6.7 per cent. That's the lowest it's been since the early '70s.

Naturally, the fall in interest rates has made home loans easier to afford. But the link between inflation and affordability is more complicated than that. The complication arises from the terms of the standard mortgage agreement, known as a "credit foncier" loan.

Under a credit foncier loan, the lender takes the principal to be repaid, adds the total amount of interest to be paid over the life of the loan, then divides the total into equal monthly repayments.

This way of determining the size of repayments makes eminent sense - in a world of zero inflation. Unfortunately, in a world of high inflation it means the loan is "front-end loaded".

That is, the effective burden of the repayments is a lot higher at the start of the loan than it is in the later years. And, because lenders aren't prepared to lend to people whose initial repayments would exceed, say, 30 per cent of their income, this arbitrary arrangement means many people on modest incomes are denied a loan.

Mr Stevens offers this example to illustrate the effect of front-end loading under high inflation. Someone wants to borrow $100,000 over 25 years. Assume first that the inflation rate is 8 per cent and that household disposable income rises in line with inflation. The corresponding mortgage interest rate is 13 per cent.

In this case, the monthly repayment represents 34 per cent of household disposable income at the start of the loan, but over the following 25 years falls to 5 per cent.

Now let's assume the inflation rate is 2 per cent and the mortgage interest rate is what it is today, 6.7 per cent. In this case, the monthly repayment represents only 21 per cent of income at the start of the loan, but falls only to about 13 per cent by the end of the loan.

From this you see how markedly our return to low inflation has reduced the front-end load and thereby made mortgages much more affordable.

You can also deduce a general rule: the higher the inflation rate, the higher the initial hurdle, but the faster the value of the repayment falls in real terms; the lower the inflation rate, the lower the initial hurdle, but the slower the value of the repayment falls in real terms.

So, as has been widely reported, housing is now more affordable than it's been for many years. But Mr Stevens makes another, subtler point. Housing finance is not only more affordable, it's also more available.

You can't really compare interest rates as they are today with rates as they were in the '60s or early '70s. Why not? Because of the change in availability.

These days, availability isn't an issue. The banks and other lenders have all the money in the world to lend you. The only constraint now is how much you can afford to borrow.

But in the days before financial deregulation, it was a different story. Although interest rates were low, the banks never had as much money to lend as people wanted to borrow.

So they found ways to ration supply. One trick was to require borrowers to have had a savings record with them. Another trick was to lend you just 30 or 40 per cent of the value of the home you were buying.

In this case, many people had to top up with a much dearer second mortgage from some other lender, such as a finance company. This meant their effective interest rate was higher than the standard bank rate.

This leads Mr Stevens to say that "the combination of affordability and availability of finance for housing seen today has not been bettered at any time in our modern economic history".

This is the respect in which economic conditions have improved markedly for those families on modest incomes - the battlers - previously priced out of the housing market.

On Mr Stevens's rough estimates, the proportion of households able to meet the banks' standard criteria to buy the median-priced house has risen since 1993-94 from 46 per cent to 55 per cent. That's an extra 600,000 households. Had the inflation rate stayed at 8 per cent, however, the proportion might have fallen from 46 per cent to 31 per cent.

And there's little doubt that many battler families have indeed taken advantage of the improvement in affordability to become home buyers.

In the five years to 1996, almost two million new loans for homes (excluding the re-financing of existing loans) were approved. This was an increase of 27 per cent on the previous five years.

Of course, not all of those loans would have been to first-home buyers. Most would have gone to existing home owners who were trading up to bigger and better homes.

That raises another point. Home loans have become more affordable, not just for battlers, but for all of us. And many of us have seized the opportunity to borrow more.

Though house prices haven't risen all that much since 1990, the average size of a new loan has risen by about 60 per cent.

The combination of more borrowers and bigger loans has dramatically increased the amount the nation's households owe on their homes. As a proportion of household disposable income, it's gone from about 36 per cent to 60 per cent.

This isn't as alarming as it sounds. Australian households are really only catching up with the rest of the developed world. Measured against disposable income, our total household debt (that is, including other borrowing as well as for homes) is still well below that for households in the United States, Britain, Canada and Japan, and about equal with Germany.

So it doesn't have to be a problem - provided we remember that, though low inflation has reduced the front-end loading on home loans, it has increased the back-end loading. The real burden of monthly repayments no longer falls away as quickly as it used to.