The household debt dilemma

04 August 2010

We assess the position of household finances, particularly the serviceability of high household debt levels.

In a recent speech titled “Aspects of Australia’s Finances”, Reserve Bank of Australia (RBA) Deputy Governor, Ric Battellino, addressed a key question often raised in financial markets: Are Australian households over-geared?

While household debt as proportion of income has stabilised over the past year, there was certainly a significant run-up in the level of debt over the past couple decades. But, what determines whether this level of debt-income is sustainable or not? Indeed, very low arrears rates suggest that Australian households have coped well with current levels of debt. And, while policymakers suggest that a further run-up in debt would not be wise, the current composition of debt suggests that household balance sheets remain on a stable footing.

According to RBA research, there are 3 key reasons why households should be able to sustain higher household debt levels than previously.

1) Structurally lower interest rates have improved the serviceability of a given level of debt. This was one factor that facilitated the run-up in debt over the past two decades, but it does still raise the concern that households are now over-exposed in a rising interest rate environment. That said, the next two reasons highlight that this is not necessarily the case.

2) While household debt has risen, so too has the level of household assets. Importantly, rising debt has not been used to increase consumption, but rather to acquire assets. RBA data shows that the rise in household debt for non-housing purposes (i.e. credit cards, car loans, etc) has been relatively contained over time. Moreover, the rise in household asset values is not only in housing, but financial assets as well.

3) The rise in debt levels has been concentrated in those households with the strongest capacity to service it. This is true in assessing the distribution of debt across different levels of income and age groups.

For example, the top two income quintiles are responsible for the bulk of the increase in debt over the last decade. Indeed, households in the top two income quintiles account for ¾ of total household debt, whereas the bottom two quintiles account for only 10% of debt outstanding.

Similarly the Reserve Bank also looks at debt levels among different age brackets. They find that the increase in debt has predominantly been in middle-aged households (35-65 year olds). It is these households that tend to have higher incomes and also recorded fewer job losses during the downturn in 2008-09.
To be sure, there do remain some concerns around the large number of first-home buyers, who took advantage of boosted government incentives over the past year. Most of these mortgages have relatively high loan-to-value ratios (averaging around 90%) and are funded by floating rate mortgages. As a result, these households are more sensitive to rising interest rates.

But, it is important to note that while these purchasers represented a large portion of house sales over the past year, they also represent a smaller component of overall household debt than may have previously been the case. This is because households under the age of 35 (making up the majority of first-home buyers) have seen a reduction in the proportion of people with debt over the past decade.

So, while current levels of household debt are high in Australia, the very low rate of arrears on loans (around 0.7%) as well as a favourable composition of debt suggests that serviceability of debt is stronger than would be suggested by the aggregate debt to income ratios.