Interest rate shock could cause problems for a quarter of home loans

Loan repayments should not exceed 40% of a household’s income to be affordable but sustained interest rate hikes could push a quarter of home loans past this threshold.

The data comes from a Central Bank of Malta study that analysed the impact of higher interest rates on borrowing costs for households.

The study analysed new loans issued between the fourth quarter of 2020 and the second quarter of this year, and subjected them to interest rate hikes of up to 250 basis points.

The study was published in the CBM's Interim Financial Stability Report released today.

The European Central Bank has increased interest rates by 200 basis points since July in an attempt to stymie runaway inflation. Interest rate hikes are good news for depositors but bad news for borrowers after more than a decade of super low interest rates.

The CBM study shows that the household loan situation will remain healthy up to an interest rate shock of 150 basis points. Such a shock is factored in by banks in line with a CBM directive issued four years ago.

However, further interest rate hikes up to a maximum of 250 basis points “would burden households’ repayment capabilities”.

Around a quarter of loans will exceed the ideal repayment-to-income ratio of 40%. “This is especially the case for those loans which at origination had already relatively more stretched borrower metrics,” the CBM said.

It noted that around half of such borrowers were first-time buyers with a loan-to-value of more than 80%, a loan-to-income of more than six times and a term to maturity of more than 30 years.

Although domestic retail banks have so far retained interest rates unchanged despite the ECB’s rapid hikes, the situation is likely to change in the coming months.

By October 2022, euro area inflation rose to 10.6%, compared to 4.1% a year earlier, way above the ECB’s 2% target. To tame runaway inflation, the ECB embarked on a path of monetary policy normalisation by unwinding its asset purchase programmes and raising its key interest rates.

Since July, the interest rate for the main refinancing operations (MRO) rose to 2%. The ECB’s Survey of Professional Forecasters for the fourth quarter of 2022 suggests the MRO rate will rise steadily to 2.6% by the first quarter of 2023 and stabilise at around 2.7% until 2024.

The increase in interest rates should translate into higher borrowing costs for households and companies, which would in turn affect consumer spending, with the aim to help cool inflation. But a rise in borrowing costs could also impact the debt repayment capabilities for existing borrowers, which could translate into higher credit risk on banks’ balance sheets.

The CBM said that although the Maltese households’ balance sheets remained strong, households are increasingly becoming more leveraged, with growth in debt outpacing the rise in their financial assets and disposable income.

Household debt stood at around 24% of financial assets and 87% of disposable income by June 2022. These indicators remained largely in line with their average since June 2009.

However, the CBM warned that should current leverage trends persist, risks to the households’ sector could be amplified, especially for the more highly indebted and lower income earners, amidst a scenario of weaker economic growth and a possible increase in interest rates.