RDP 2019-06: The Effect of Mortgage Debt on Consumer Spending: Evidence from Household-level Data Appendix B: Institutional Features of the Australian Mortgage Market

The theoretical model indicates that liquidity constraints (either now or in the future) can drive the relationship between debt and spending. KVW (2014) outline a model to identify liquidity-constrained or ‘hand-to-mouth’ households. In this model, the consumption of some households is very sensitive to shocks to current income despite high levels of wealth. Some households hold wealth in illiquid assets, such as housing, and still act as if they are constrained because their liquid wealth is low. These households may adjust their spending even in response to transitory (and predictable) income or wealth changes. KVW (2014) apply this framework to household-level data for a range of countries, including Australia. La Cava, Hughson and Kaplan (2016) extend KVW's Australian results to study the evolution of hand-to-mouth households over time and examine how these households influence the sensitivity of aggregate household spending to monetary policy shocks.

There are a couple of features of the Australian mortgage market that are unique by international standards and affect the extent to which households are ‘hand-to-mouth’. Most borrowers have offset accounts or redraw facilities linked to their mortgages. These loan features make housing wealth more liquid than otherwise; they reduce the transaction costs involved in prepaying mortgages and make it easier to build buffers that can be used to offset income or wealth shocks.

An offset account is an at-call deposit that is directly linked to the mortgage. Funds deposited into an offset account reduce the borrower's net debt and the interest payable. A redraw facility enables the borrower to withdraw principal payments that they have made ahead of the required schedule. Mortgages with offset accounts currently comprise around 45 per cent of the total value of residential mortgage debt in Australia. Mortgages with redraw facilities make up around 70 per cent of the total number of residential mortgages in Australia (APRA 2019).

These mortgage features provide a tax-effective method of saving. First, the deposit rate that the borrower earns on the balance is equal to the mortgage interest rate. Second, the account generates no tax liability compared to depositing money into a separate savings account where any interest accruing adds to taxable income. This means there can be large tax advantages for borrowers to retain funds in a mortgage offset account (mortgage interest payments are not tax deductible for owner-occupier loans, though they are for investor loans, which are not considered here).

The main differences between offset accounts and redraw facilities are the degree of liquidity and the effect of withdrawals on home equity. In terms of liquidity, the funds sitting in an offset account are at call and easily accessible for withdrawal and for purchasing goods and services. The money in a redraw facility, while accessible, is not generally available for same day, at call withdrawal. There may also be a fee associated with redrawing money from the loan. A withdrawal from an offset account does not affect the principal balance of the loan, whereas a withdrawal from a redraw facility increases the principal and hence reduces the equity in the home.

Another feature of the Australian market is the high share of mortgages that do not face prepayment penalties. Over 80 per cent of home mortgages in Australia are originated at variable (or adjustable) rates and these mortgages can be prepaid without penalty. The combination of no prepayment penalties, tax incentives and highly liquid offset accounts means that Australian mortgage borrowers typically build up liquidity buffers by prepaying their mortgages. These buffers imply that housing is not as illiquid as that implied by the KVW (2014) framework.