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Wednesday, 27 March 2019

How do debt ratios come down?

Debt bomb deflation

A question for today: we have heard that debt levels are high in Australia, so how do household debt ratios actually come down?

There is no one simple answer.

Rather it's a combination of a whole range of factors coming together.

I'll look at ten of the ways below. 

Firstly, it's important to note that the debt to disposable income in Australia peaked 9 to 12 months ago, and now sits at 1.89 times disposable income.

So it's not over two times income (or even three times!), as is sometimes claimed, and the ratio is not still rising. 

There's been a lot of alarmist reporting about this (surprise!) but these things can have a way of balancing themselves out, and within about 18 months the ratio will probably have eased to more comfortable levels.

We will also likely see debt serviceability ratios declining to remarkably easy levels, as we'll see below.

Source: ABS

So how does the debt ratio come down? 

Here are ten of the ways:

1 - Slower mortgage growth

Monthly housing finance has come down from around $35 billion to under $30 billion as fewer transactions are taking place, and dwelling prices have fallen from their peaks. 

2 - Negative growth in personal debt

Personal credit has been in outright decline for years now (hardly a sign of chronically stressed household finances, it must be said). 

3 - Fewer new interest only mortgages

Now down to about 15 per cent or so of new loans, from nearer 40 per cent at the peak, so more people are now paying down their mortgages immediately.

4 - Lower fixed mortgage rates

Funding costs and fixed mortgage rates are falling, allowing for greater mortgage prepayments.

5 - Loan switching

There's been a massive voluntary migration across from interest-only (IO) to P&I mortgages thanks to the more favourable terms. IO loans may be only about a fifth of mortgages by value by the end of 2019, which is an enormous shift from nearly 40 per cent at the peak.

6 - Tax cuts

Bracket creep has seen real tax payable per capita rising relentlessly for the past five years. This has balanced the Federal Budget, but now it's time for some tax cuts to be delivered back to households (note that disposable income in the chart above is calculated after tax). 

7 - Rate cuts

The market is now pricing in two further interest rate cuts by August 2020. This alone doesn't reduce debt ratios, but it will give households plenty more breathing space to make faster repayments if desired. 

8 - Accelerated repayments

The ABS figures for household finances and wealth will be released tomorrow, and this will show how interest payable to income ratios have fallen dramatically over the past decade, allowing households to build up a war chest of cash and deposits totalling more than $1,150,000,000,000. 

This is totally unprecedented, and shows that the 'record' household debt story is only one part of the equation. 

9 - Income growth

Wages growth has been very slow in recent years, but is now off the lows and rising back towards 3 per cent per annum.

Household income growth is projected to rise further over the years ahead. 

10 - Slower SME loan growth

Another impact of the credit squeeze has been less credit being made available to sole traders and small business owners. 

The wrap

This is just a brief overview of a far more complex story, but offers a few insights into a few of the ways in which the household debt to income ratio will now ease back.

The reality is households have been building up enormous mortgage buffers in recent years, so with a bit of netting down the issue could become a non-issue relatively soon.