Why is the Reserve Bank worried about high household debt levels?

In its May Financial Stability Report, the Reserve Bank of New Zealand revealed the results of stress tests designed to assess the vulnerability of households to service their mortgages if rates rise.

Its findings show a high number of owner-occupier households would be under financial stress if rates jump, which could collapse the housing market as defaults rise and demand weakens further.

The central bank considered a 7% mortgage rate, close to the average for a two-year loan over the past decade, and a 9% rate which it says is “extreme but still plausible”.

At a 7% rate, the bank estimates that 4% of all borrowers (6% of the total stock of mortgage debt) and 5% of recent borrowers (9% of the total) would be unable to manage their essential expenses. A further 9% of all borrowers would have only a small buffer for discretionary spending.

At a 9% mortgage rate, 7% of all borrowers and 19% of recent borrowers would be unable to manage.

“While the LVR restrictions have increased the banks’ resilience to any fall in house prices, a significant share of housing loans are being made at high debt-to-income (DTI) ratios. Such borrowers tend to be more vulnerable to any increase in interest rates or declines in income,” said RBNZ Deputy Governor Grant Spencer.

The report warns that Auckland’s mortgage borrowers are at a higher vulnerability to increased rates with 5% in the city estimated to be unable to meet essential expenses at a mortgage rate of 7%, compared to 3% elsewhere.

With high levels of New Zealand’s homeowners vulnerable to mortgage rate rises, the central bank forecasts that a sharp and unexpected hike in rates could see defaults increase, consumption cut, and homes being sold to pay debts.