Consumers are being pulled in two directions at once. The Reserve Bank's decision to cut the cash rate by 50 basis points will make home loans more affordable and encourage buyers. But the news that house prices are falling will also cause concern.
Both the Australian Bureau of Statistics and RP Data-Rismark reported earlier this month that house prices around the country have fallen by an average of 4.5 per cent over the past 12 months.
A fall in house prices makes home owners feel less wealthy than they were. And the constant stream of job losses adds to the gloom, making people feel insecure about their jobs and the level of debt they are carrying.
So the larger-than-usual rate cut comes as welcome relief, as do signals from the Reserve Bank that further interest rate cuts are a possibility.
The 50-basis-point cut represents a $96 a month reduction in mortgage payments for home buyers with an average-size loan of $300,000 (assuming the full cut is passed on).
But for people who can afford to maintain their payments at their current higher level it presents a great opportunity to make inroads into their outstanding principal and build a buffer for tougher times.
Given the uncertainty in markets, and the economy, it is a good strategy to build greater equity in the home.
Customers of Australia's biggest home lender, Commonwealth, will save $77 on their monthly payments on a $300,000 loan, when their rate drops 40 basis points from 7.41 per cent to 7.01 per cent. If customers keep making payments at the higher monthly repayment amount they will pay off their loans in 22 years and 10 months, cutting two years and two months off the term and cutting the total repayment by $57,800.
A customer with a $500,000 loan will save $128 a month after the rate cut. If they keep their repayments up at the higher rate they will reduce their term by two years and two months, and cut $98,664 off the total cost of their loan.
Paying more into your mortgage not only offers savings but provides insurance against adverse events.
To do calculations, go on the MoneySmart website of the Australian Securities and Investments Commission (moneysmart.gov.au/tools-and-resources/check-asic-lists).
FALLING HOUSE PRICES
Falling prices are an unusual occurrence in the Australian residential property market and are, therefore, an unknown quantity.
The interest-rate cut will provide some stimulus but property market cycles tend to be longer than equity market cycles, with slow recoveries.
Buyers may need to take some guidance from investors in markets where price falls are a regular event, such as the equity market. Investors who borrow to buy shares have learnt that the way to stay out of trouble is to gear at low loan-to-valuation levels and have a savings buffer. Home buyers also need to be more careful about where they buy. Some areas have suffered heavier falls than others.
As the table shows, fixed rates, which provide more certainty, are available at under 6 per cent - a full percentage point lower than variable rates at the big banks.
One of the things that has changed as a result of flat and falling house prices is that people stay in the same loan contract for longer. So it is worth making sure such a contract has the features you want.
A weak real-estate market changes the dynamics of the home-loan market.
Broker Mortgage Choice reports that the average life of the $43 billion in loans on its book has increased from 3½ years in 2006 to the current average of five years.
The managing consulting director of Fujitsu Consulting, Martin North, says his data shows that the average life of a mortgage has increased from about 28 months four years or five years ago to 45 months today. He says lower growth or falling house prices mean people are holding on to their properties for longer. That is because it takes them longer to make a capital gain.
And North says people are refinancing less often.
If they have not accumulated much equity in the property there is little to be gained by refinancing and lenders are less enthusiastic about winning their business.
Refinancing is often a way of overcoming debt stress. People who find that they are not coping with their maxed-out credit cards and other commitments will refinance to consolidate their personal debt with their mortgage, get a longer term and maybe a better rate discount.
The fact that the refinancing option is not so readily available in the current environment could spell trouble for over-geared borrowers.
According to QBE LMI's 2012 Australian mortgage market survey, 21 per cent of people who refinance do so in order to consolidate debt.
Roy Morgan Research has estimated that the latest cut in interest rates will lead to a significant reduction in the number of Australians experiencing mortgage stress - people who are considered to be ''at risk of failing to repay their mortgages''.
However, the number at risk is still large - 776,000 people, or 16.8 per cent of Australians with mortgages.
The number looks high but it is consistent with other survey results.
According to the latest ING Direct Financial Wellbeing Index, published last month, one in five households are ''very uncomfortable'' about their ability to pay bills on time.
The chief executive of Westpac, Gail Kelly, was asked about the impact of falling house prices on loan security when she presented the bank's March half-year results last week. Kelly said the bank was keeping an eye on valuation movements, especially in Queensland and centres along the east coast.
The executive director of banking and financial services at the Macquarie Group, Frank Ganis, says: ''A lender has to be mindful of what is going on in the property market. You always have to look at the possibility that you may have to sell the security to recover the loan.
''A 4 per cent fall in house prices does not lead to a significant change in lending practices. What drives the performance of a mortgage is the capacity to repay.
''But we are paying attention to housing market movements. We are making sure the borrower's ability to service the loan is strong, that the loan size is right and that the house being purchased is in the right area.''
The head of lending at Centric Wealth, Sheyne Walsh, says these are good disciplines for borrowers to impose on themselves. He says borrowers can protect themselves against the risk of mortgage stress by being sensible about the loan size they take on and by using fixed rates as insurance if rising rates would make repayments difficult.
''I ask people what they are earning and what they were earning two years ago,'' Walsh says. ''If it has not changed in that time then a lot of the conversation will focus on fixed rates.''
First-home buyers take on the most debt. According a J.P. Morgan and Fujitsu Consulting mortgage-market study published in March, about 25 per cent of first-home buyers borrow on loan-to-valuation ratios of 90 per cent to 95 per cent, and 10 per cent borrow on LVRs of more than 95 per cent.
Compared with this group, the overall average LVR is 66 per cent.
The reason first-home buyers gear up so much is that it takes years to save for a deposit. QBE LMI's survey found that first-home buyers saved an average deposit of 19.3 per cent of the property price and it took them an average of four-and-a-half years to save the money. Surprisingly, people shopping for a loan do not pay all that much attention to product features. They are very focused on rates and fees, despite the fact offsets, redraws and loan-splitting facilities can make a big difference to loan security and accelerating repayments.
Respondents to QBE LMI's survey gave interest rate 8.2 out of 10 when they were asked to rate the factors that were important to them when selecting a loan. They scored fees six out of 10. The availability of a redraw was scored 2.9, offset account 2.8, package options (which save money) 2.7 and the ability to split the loan between fixed and variable rate components scored 2.4.
''The real buying trigger for consumers is the perceived cost of the mortgage rather than the functionality and features that come with the mortgage,'' the report says.
Couple escapes rental trap
Gemma Black and Paul Chilton took the plunge last year into home ownership.
They decided they were sick of dealing with real-estate agents and wanted to have a place of their own.
The first-home buyer strategy that Black, 24, and Chilton, 28, formulated ran along familiar lines. They moved in with Chilton's parents so that the money they would have been spending on rent could be saved and go towards a home-loan deposit.
Black, a journalist, and Chilton, a renewable-energy engineer, agreed they would wait until they had saved a 20 per cent deposit.
They started their property hunt in Marrickville in Sydney's inner west, where they thought they would find the best mix of value for money and lifestyle.
One issue they had to consider was a change to the NSW Office of State Revenue (OSR) first-home benefits.
In addition to the $7000 First Home Owner Grant, the OSR had an exemption on transfer duty for first-home buyers, offering savings of up to $17,990.
That exemption, First Home Plus, was to expire on December 31 last year.
Black says she and Chilton were not in a hurry to buy and did not want to rush their search merely to secure the extra benefit. But it was an issue that had to be considered.
The fact that house prices in Sydney were falling concerned them but did not put them off.
"We were not buying as an investment,'' Black said.
''We were sick of dealing with real-estate agents and we wanted a place we could stay in for quite a few years."
Once they started looking, things moved faster than they expected. They shifted their focus to Sydney's northern beaches, where Black grew up. Chilton is a surfer and the couple are both at the beach often.
In November they found a Dee Why apartment they liked.
Even though they had only saved enough for a 5 per cent deposit, they bought the property for $489,000.
On the advice of a broker, they took out an interest-only loan.
They also set up an offset account, which is where their salaries go. The idea of the interest-only loan combined with the offset account is to give them flexibility. They can use the money they save in the offset account to pay off some of the principal loan amount, renovate or put towards a second property.
Black says they are managing the monthly interest payments without any strain.
"We could have spent a bit more," she says.
"We have one car. We were together at uni, when we did not have a lot of money to spend, and we haven't changed our lifestyle all that much."
There is enough money left in the household budget for Black and Chilton to be considering a trip to Britain at the end of this year to see Chilton's relatives.
A home borrower's handbook to keep you out of trouble
❏ Know what you can afford. Don't rely on the lender to tell you what you can borrow. Make your own assessment by writing a household budget with all outgoings and see if there is enough to cover the mortgage repayment. According to Veda Advantage and Fujitsu Consulting mortgage stress reports, the groups that most often get into trouble with repayments are low-income families and young families.
❏ Don't just look at the rate. According to QBE LMI's 2012 Australian mortgage market study, when people are looking for a loan they place most emphasis on the interest rate and the fees. Options such as redraw, offset and the ability to split the loan between fixed and variable rates are given a low priority.
❏ Stress-test your loan. Lenders will check to see if you can continue to make payments if rates go up 2 percentage points. What if rates go up 3 percentage points or more?
❏ Watch your credit-card spending. Surveys of people experiencing hardship with home-loan repayments show that large credit-card debts can be the trigger for arrears or defaults.
❏ Make extra repayments. According to ING Direct's Financial Wellbeing Index, 40 per cent of mortgage holders are making extra repayments on their home loans. These payments serve two purposes: they create a buffer that can be called upon if circumstances require; and they speed up the repayment of the loan.
❏ Invest in your mortgage. A lump-sum payment that reduces the loan principal is, in effect, an investment with a return equivalent to the mortgage interest rate, free of tax.
❏ Deal with problems early. The Legal Aid Mortgage Stress Handbook recommends that borrowers seek advice early from their financial institution or a financial counsellor. Many people leave it too late.