Social Trends – Page 171 – Digital Finance Analytics (DFA) Blog

A home of your own: dream or delusion?

From The Conversation. The appeal of owning a home seems deeply embedded in the psyche of Australians. Yet psychologically, it is not clear the home ownership dream is entirely rational. Achieving the dream may not be all we might have hoped, and chasing it may even do damage.

We’d all like a castle of our own, one day. Image sourced from Shutterstock.com

The psychological reason Australians want to own their own home is perhaps best expressed by Darryl Kerrigan in the uniquely Australian film, The Castle. It continues to be celebrated globally for showing that the house is just a shell that holds heart. To own your own home has a strong sentimental value, as Darryl says: “You can’t buy what I’ve got.”

According to data on social trends from the ABS, the dream is not merely a distant aspiration, but one achieved by a majority of the Australian population. More than two out of every three Australians are living in their own home, a figure that has been maintained across a number of decades (see below).

Australian Bureau of Statistics ABS Australian Social Trends 6530.0 & 4102.0

However, the data also show that the proportion who own with a mortgage is increasing (and the proportion without is decreasing). So the dream continues to be made a reality even if home buyers need to borrow more money to achieve it.

Dare to dream

What harm can there be in having dreams? Well, there is a sizeable minority who perhaps do not achieve their dreams. And dreams that keep us awake at night are not good.

Joe Hockey’s recent remarks suggesting would-be home owners “get a good job” were labelled as insensitive and drew a great deal of ire.

The public reaction reinforced the fact that we have a strong attachment to the dream of owning our own home. But why this attachment? While we need a place to live, and housing is for many a form of retirement saving, the desire to own our own home goes beyond these needs.

It’s a global desire, judging by the substantial home-ownership rates around the world – from 98.7% in Romania to 44.0% in Switzerland.

Across cultures and across age groups, one of the motivations for possession of anything is to have the ability to control that possession. In the case of a house, this might be to nail up pictures, paint walls and remodel the place.

The real cost of ownership

But this desire to own, the wish to possess, comes at a cost. First, there is considerable research suggesting we tend to overweight the value of owning stuff as opposed to simply having access to use. Called the endowment effect, it describes the way in which we tend to place a higher value on an item that is owned than on an identical item which is not owned.

Surprisingly, and perhaps of greater concern, is that ownership of a home does not appear to necessarily make people happier. One researcher found that women who owned their own home were no happier than those who rented.

More generally, the rent vs buy debate seems to focus the issue on elements that turn out to be less relevant to our longer-term happiness. We make choices based on big differences (such as rent or buy) when the two dwellings are in most other respects, very much the same.

In this case, we are falling for the focusing illusion whereby we exaggerate the joys of home ownership. Psychologist Daniel Kahneman explains this concept with regard to the myth of California happiness.

And once we get to be a home owner, the pleasure we so anticipated can quickly disappear through the phenomenon of hedonic adaptation. We imagine that owning our own home will make us very happy, and while this may be true in the short run, our happiness levels return quickly to whatever they were before the event.

Hedonic adaptation diminishes both acute negative and positive experiences. And this may explain why home ownership rates and desires bounced back quickly in the US despite the punishing lessons delivered during the global financial crisis of 2008 when many held mortgages of greater value than their home.

We might be inclined to argue that home ownership is a good investment, that “rent money is money down the toilet”, but we may be engaging in a confirmation bias. That is, interest and council rates are a similar “waste”, but we discount this argument because we already believe home ownership is good.

In any case, the walls and roof within which we live do not make the home. While we may justify our dreams with reasons, the truth of the home ownership dream is probably closer to the heart than the head.

Author – Stephen S Holden Associate professor at Bond University

The Rise, and Rise, and Rise of Investor First Time Buyers

DFA has just released the latest analysis of survey results which shows that nationally 35% of all First Time Buyers are going direct to the Investment sector. However there are significant state differences, with more than fifty percent of transactions from first time buyers in NSW, and upticks in other states as the behaviour spreads. You can watch our latest video blog on this important subject.

Here is the data we used in the video. The first chart shows the national average picture, using data from the ABS to track owner occupied first time buyers (the blue area), data from DFA surveys to display the number of FTB investment loans (the yellow area), both to be read from the left hand scale, and the relative proportion of loans using the yellow line on the right had scale. About 35% of loans are going to investment first time buyers.

In NSW, the rise of investors has been running for some time, and as a result, more than 50% of loans are First Time Buyer investors. Note the growth thorough 2013.

In QLD, until recently there was little FTB investor activity, but we are seeing a rise in 2014, to a peak of 12%

The rise of FTB investors in VIC started in 2013, but is now growing quite fast, to about one quarter of all FTB activity.

Finally, in WA, where OO FTB activity is quite strong, we are now seeing the rise of FTB investors too. Currently about five percent are in this category.

There is a clear logic in households minds. They see property values appreciating in most states, yet cannot afford to buy a property for owner occupation in a place where they would want to live. So they choose the investment route. This enables them to purchase a cheaper property elsewhere by grabbing an investment loan, often interest only and serviced by the rental income. In addition they get the benefits of negative gearing and potential capital appreciation. Meantime they live in rented accommodation, or with families or friends. About ten percent of recent purchasers have received some help from “The Bank of Mum and Dad“. Finally, some see the investment route as a means to build capital for the purchase of an owner occupied property later, though others are now thinking more in terms of building an investment property portfolio. They are on the property escalator, with the expectation that prices will continue to rise.

There are some significant social impacts from this change, and there are probably more systemic risks in an investment loan portfolio, which should be considered. We are of the view that the recent APRA “guidelines” will only have impact at the margin, so we expect to see continued growth in FTB investment property purchases for as long as interest rates stay low and property values rise.

The Facts on Australian Housing Affordability – The Conversation

From The Conversation. Housing affordability, high house prices and rents are attracting plenty of media attention right now. The latest figures on house prices, mortgages, number of first time buyers and so on are dissected by journalists and commentators as if this is an issue of recent origin. In fact what we have here is a long-term structural problem that has been neglected for decades.

Back in 1982, the ABS Survey of Income and Housing revealed that 168,000 or 10% of home buyers spent more than 30% of their gross household income on housing costs. Nearly 30 years later in 2011 these numbers had soared to 640,000, equivalent to 21% of all home buyers.

The trends in housing cost burdens reflect rising real house prices. The history of house prices over this timeframe is one of booms in which real house prices escalate to higher levels than they peaked in the previous boom. Periods of house price stability punctuate these booms, and give household incomes some breathing space in which to catch up.

But at each peak in house prices, household incomes have fallen further behind. According to the same ABS data source, households in 1990 on average valued their homes at a multiple that was four times their average household income. By 2011 this multiple had climbed to nearly six times average household income.

A generational threat

It is therefore not surprising to find that young first time buyers are finding it increasingly difficult to purchase a home. As our first table shows, on a person basis the rate of home ownership in the prime 25 – 34 year age group has slumped from 56% in 1982 to only 34% in 2011. Delayed entry into home ownership is a factor, but it turns out that these declines have set in across all but the post-retirement age group. The “Australian dream” of home ownership is under threat.

Home ownership rate 1982-2011, in percentage terms

How have we reached this position? To be sure population growth, low interest rates, deregulation of mortgage markets and rising real incomes have helped fuel the demand for housing, and pushed up real house prices. But there are deep seated structural problems that contribute to an inflationary bias in land and property markets.

Fiscal concessions in the form of capital gains and land tax exemptions to home owners, negative gearing and concessionary capital gains tax for “mum and dad” investors, and asset test concessions to home owner retirees offer powerful incentives to accumulate wealth in housing assets. As a result, the supply side problems are not so much about a shortage of housing, but an inefficient distribution of the stock of housing.

According to the 2010 Household, Income and Labour Dynamics in Australia Survey, roughly 1 in 6 Australian households own two or more properties, and for 30% of these households the second property is a holiday home. Growing numbers of ageing “empty nester” households are deterred from downsizing and releasing housing equity by stamp duty, the taxation of alternative investments of the equity released, and the lack of suitable housing opportunities in the communities they would like to stay in.

Meanwhile according to the latest census more than 100,000 Australians are homeless, and many more than this are struggling to meet housing payments.

The supply issue

Back in the early 1980s these fiscal drivers did not matter so much, because there were ample greenfield sites on which new housing could be constructed. These sites still offered reasonable access to amenities and jobs. But such opportunities are drying up, and state governments have introduced curbs on urban expansion, as well as developer charges and fees that have increased the costs of construction on the urban fringe.

Adding to supply side problems are planning controls that impede higher density development in middle ring suburbs, as “insider” home owners understandably seek to protect the “leafy character” of their communities.

We are left with a problem that has wider ramifications because it has created a housing system saddled with growing indebtedness. In the 21 years illustrated in the chart below the average mortgage debt has soared relative to the average household incomes of mortgagors in all age groups.

Mean mortgage debt to income ratio

Moreover, the proportion of home owners with outstanding mortgage debt has increased, especially in the 55–64 year cohort that is typically approaching retirement (see chart below). Interest rates were much higher back in 1990 and so household incomes in 2011 can comfortably service loans that are larger relative to household income.

Percentage of home owners with a mortgage debt

Nevertheless repayment risks and investment risks (house values falling short of outstanding mortgage debt) loom more prominently, and for a larger number of precariously positioned households. These risks could test the resilience of local economies and the national economy.

The Australian housing system weathered the global financial crisis much better than did many of its counterparts in the developed world.

Does this suggest a resilience that we can bank on in the future? Federal and state governments might be well advised to introduce structural reforms to housing finance that strengthen that resilience.

Authors, Gavin Wood, Professor of Housing at RMIT University and Rachel Ong, Principal Research Fellow, Bankwest Curtin Economics Centre at Curtin University

Making Residential Rental Markets Work for Financial Stability

In an address by Stefan Gerlach, Deputy Governor (Central Banking) of the Central Bank of Ireland, at the Twenty-First Dubrovnik Economic Conference, Dubrovnik, he discussed the rise of the rental market, and the potential implications for financial stability, with specific reference to what happened in Ireland post the GFC. There are some important observation for Australia.

He concludes that economies that experienced boom-bust cycles in housing, such as Croatia and Ireland, suffered disproportionately in the financial crisis. There were numerous reasons for this large impact, many of which are, by now, very familiar. However, it is less frequently noted that those economies with deeper rental markets suffered less. While the specifics of housing policy are outside the remit of central banks, it is incumbent for us to draw attention to issues that relate to financial stability. To reduce the risk and the amplitude of future housing cycles, housing policy needs to consider also financial stability issues. In this regard, it seems particularly important to promote a well-developed rental market as a genuine alternative to ownership, and an attractive investment proposition for potential landlords. While many households may continue to buy rather than rent, we need to make sure that this choice reflects their preferences and does not merely reflect a poorly functioning rental market.

4. The role of mortgage debt in a financial crisisThere are of course also a number of social benefits from owner-occupancy which need to be kept in mind. For instance, owner-occupancy represents the purchase of an asset and, since mortgage loans are amortised in Ireland, therefore leads to wealth accumulation. This can be particularly helpful in retirement, when reduced income can be offset by the lower cost of outright ownership of housing. In addition, studies have shown that homeowners are more engaged in social and political activities, have more positive assessments of their neighbourhoods, better psychological health and higher educational attainments. Surveys in the US show that homeowners believe their neighbourhoods are safer and better places to raise children.

But while the benefits of owner-occupancy are well documented, there is a much less well-known flipside to this coin: the risks associated with financially vulnerable households taking on the financial burden of house purchase. Let me now discuss this issue.

In Ireland the burden of the current crisis has fallen squarely on the young, many of whom bought property at the top of the market. The perception that one must get “on the property ladder” as soon as possible that was a particular feature of the boom years, but also a consequence of the poorly functioning rental market in Ireland, has had implications for younger families. Many of these are now left with unsuitable properties for their housing needs (for example, one bedroom apartments that are not satisfactory for growing families), and with debts that they could no longer service when salaries declined and unemployment rose during the economic downturn. Moreover, negative equity and mortgage arrears may make it difficult for them to move in pursuit of new, or better paid, employment. While desirable and beneficial for many, homeownership does come together with important risks that many neglected before the onset of the crisis.

A particular concern in this regard is the fact that the risk of becoming unemployed or experiencing income losses is not evenly shared across society. Younger and less experienced workers, and those who work in industries that are sensitive to the business cycle, such as the construction sector, are particularly exposed to the risk of unemployment.

The crisis has disproportionately affected unemployment rates among younger age cohorts in Ireland. Graduate salaries have declined significantly since 2007, which has long-term implications for the earning potential of young people. Employment in the sectors most vulnerable to the economic cycle, such as construction, has been most adversely affected by the crisis.

Thus, the lack of a deep and well-functioning rental market forces all households, including those at a relatively high risk of unemployment, into the property market. While the great majority of borrowers are credit worthy and will service their loans, unemployment and income loss, which may be caused by the unemployment of a spouse or partner, have been important determinants of mortgage arrears in Ireland. Banks in economies with very high house ownership rates may therefore experience high credit losses in a downturn.

The resulting link between highly-indebted and financially more vulnerable households and the banking sector can create a cycle which is both self-reinforcing in good times with expectations of increasing capital values increasing equity and enabling greater indebtedness, and in bad times as both banks and households suffer losses.

What role can rental markets play? Buying a house using a mortgage is a risky leveraged investment that involves a household borrowing several times its annual income to buy an asset with an uncertain future value. Such investments should only be entered into by those that understand the risks and feel able to assume them. Moreover, the rental market can alleviate the risk of capital loss and negative equity, increase labour mobility and thus facilitate the adjustment following adverse economic shocks. From a financial stability perspective it is therefore important that households that worry about the risks of homeownership have the option, if they wish, to rent a property that provides the type and quality of housing, and security of tenure, that they require. Let me next turn to the rental market.

5. The private rental market

It is clear that in Ireland, in contrast to elsewhere in Europe, renting a home is not seen as a long-term option for households. Indeed, results from a recent survey show that over 70 per cent of private rental tenants would prefer to own their own property, and just 17 per cent wish to rent long-term. While this may reflect a cultural preference, or the benefits of homeownership, it seems more than likely that the type, quality, affordability and, in particular, security of tenure of private rented accommodation also plays an important role.

What can be done to make renting a more attractive long-term alternative to homeownership? I believe that there are three aspects to this problem: first, the rental market structure, particularly in terms of security of tenure, can play a role. Second, the investment horizons of landlords are important. A culture whereby the market is dominated by landlords seeking an income stream over the long term, rather than a capital gain in the short run, can help raise the attractiveness of renting in a number of ways. Finally, in many countries, policies aim to specifically incentivise homeownership, to the detriment of the rental market.

5.1 Security of tenure

A particular concern in Ireland is the absence of long-term rental contracts; while households may wish to stay for long periods in their accommodation, rental contracts in Ireland are predominantly of a year’s duration. This leads to a wide-spread lack of security of tenure. Indeed, a recent survey indicated that 23 per cent of private tenants in Ireland are afraid of losing their home. In addition, 32 per cent have no formal lease, even though more than half have been living in their current accommodation for more than two years. The risk and the associated costs of having to move may make households opt to purchase their own home and take on financial risks that they may feel they are not well placed to assume. Indeed, 29 per cent of tenants say that they would be more likely to rent long term if there was the possibility of a longer term lease. ¹⁴ Lengthening rental contracts therefore seems desirable. ¹⁵ Interestingly, research has shown that in countries with comparatively strong security of tenure and high rental rates, such as Germany and the Netherlands, security of tenure is seen to foster long-run demand for renting and rental investment, such that neither tenants nor landlords have sought to weaken security.

Why are rental contracts in Ireland of such short term nature? Ireland’s history of high and variable inflation and the lack of institutional investors in the rental market must both be important. In economies with a history of inflation, banks protect themselves by lending at flexible interest rates. In turn, with mortgage costs varying over time, renters protect themselves with short term contracts. In contrast, in economies with a history of low and stable inflation, mortgage lending tends to be for long maturities and rental contracts tend to be longer term.

Of course, Ireland’s history of inflation is now over. But lending arrangements change slowly. Overall, housing markets and financial stability in Ireland would benefit from borrowers having a wider choice of fixed rate loans.

5.2 Incentives of landlords

The lack of institutional investors in the rental market is also important. The Irish rental market is dominated by private households who let a single property. The fact that they may need the dwelling for a family member, or may wish to sell it, is another factor that makes for short-term contracts and concerns about the security of tenure. Furthermore, buy-to-let properties have the highest rate of mortgage arrears. The latest figures from December 2014 show that over 25 per cent of buy-to-let mortgages are in arrears. Indeed, survey findings suggest almost 50 per cent of all landlords cannot cover their loan repayments with rental income. Overall, 29 per cent of landlords intend to exit the market as soon as possible.

In contrast, institutional investors, such as pension funds and insurance companies, have very long investment horizons and have strong preferences for tenants who stay for an extended period of time, since finding new tenants and refurbishing apartments for them is costly. Institutional investors can bring a standardised, professional approach to the management of entire buildings of apartments, aiding the supply of suitable accommodation in popular areas. This suggests that attracting more institutional investors would promote a well-functioning rental market that is so important for financial stability. ²¹ Furthermore, these investors are likely to be less leveraged and have more diversified portfolios than individuals owning one or two rental properties, and are thus better able to withstand an economic downturn.

There is a wide variety of government intervention in rental market, from the direct provision of social housing to the regulation of the private rented sector. Because moving is costly and disruptive, the tenant-landlord relationship is inherently asymmetric. Regulation, if designed well, can therefore improve outcomes. That said, poorly thought out regulation, in particular rent controls, can have adverse effects by reducing the supply of rental properties and discouraging new construction and the maintenance of existing rental properties. Getting housing regulation “right” – a task outside the central bank’s remit – is important.

5.3 Policies favouring home-ownership

Home-ownership brings many benefits, and it is understandable that there are policies in place to enable house purchase; I have already outlined the potential benefits in terms of asset accumulation and social advantages associated with home-ownership. However, some policies aimed at enabling people to gain from the benefits of home-ownership have the effect of worsening the situation of those who either choose not to be homeowners, or cannot afford to be so.

One important issue that influences households’ choices between buying and renting property is tax policy. In many countries it is generally favourable towards homeownership. Examples of favourable taxation treatment of housing include the exemption of imputed rental income on principal homes from income tax calculations, tax relief of mortgage interest payments, exemptions of capital gains from the sale of principal homes, and the use of outdated housing values for property taxes.

A favourable tax treatment of homeownership risks encouraging excessive leverage and housing investment, leading to the development of macroeconomic and financial imbalances. ²³ It can also tempt households that are worried about the risks inherent in mortgage borrowing into house ownership. Overall, it seems desirable for tax policy to be neutral between homeownership and renting. To this end, it is important to note that tax relief on mortgage payments have been phased out since the crisis, and a recurrent property tax has been introduced, in Ireland.

The Hidden Victims of Rising House Prices

Australia needs to have a housing conversation that isn’t just about housing “bubbles”, profits and investment properties says an article in The Conversation.

Sadly, we punch well above our weight in international measures of poor housing affordability, and increasing numbers of Australians can’t afford their rents or mortgages.

Even a modest increase in house prices will make things even tougher for these Australians – but importantly, do we reliably know who they are, where they live, and how extreme their affordability problems are?

Our new research reveals some poorly understood distinctions in unaffordable housing. Some people appear to be “slipping” in and out of housing affordability problems, while others remain “stuck” with them for long periods, or even a lifetime.

When we look at housing affordability in this way and compare these two groups of people, these “slipper” and “sticker” groups are shown to be very different within Australian society, with different intervention needs implied.

Limitations of the 30/40 rule

To address housing affordability and target assistance we usually rely on data on the prevalence and nature of unaffordable housing. The most widely used measures of housing affordability are based on simple ratios, for example, the 30/40 measure. This approach classifies people as being in unaffordable housing if they are in the lower 40% of the income distribution and their rent or mortgage payments exceed 30% of their income.

Such a simple, straightforward measure – that classifies people as being either in unaffordable housing or not – is undoubtedly useful, and outside of the housing research community, data using these measures are rarely questioned. But it’s useful to think about that data a little more critically.

The picture of housing affordability portrayed by most of the measures we (and policy makers) rely on is a snapshot – a point-in-time collection of people’s ability to afford their housing (on Census night for example). Importantly, it’s a very blunt measure. In fact, when we look more closely at people’s experience of affordability problems we see that the snapshot is a pretty poor predictor of longer-term unaffordability.

For a great many households, both income and housing costs – and where they sit relative to other households – change a lot over time. This causes people to slip in and out of unaffordable housing. In a large Australian sample, we see that hidden within the segment of the population classified as being in unaffordable housing in any one year, fewer than half were classified in the same way the next year. Because the total number of people counted in unaffordable housing is stable, it points to a limitation in the way that we measure housing affordability.

Slippers and stickers

By following people’s income and housing costs each year for a five year period, we classify stickers as being in unaffordable housing (using the 30/40 rule) in every one of the five years. To be classified as a slipper, people must have made at least one transition into, and one out of, unaffordable housing over the five year period. Slippers outnumber stickers three to one, and therefore affordability initiatives may be more concentrated upon the needs of slippers.

Compared to slippers, stickers have much lower incomes and employment rates. Around 60% of stickers have a disability, and twice as many are carers for other people in their household. Looking deeper, three quarters of those stuck for long periods in unaffordable housing are women, they also tend to be much older than slippers, and more likely to live alone.

This description points to what some might call a vulnerable group of people or even an “underclass” perpetually facing housing affordability issues and, most likely subject to the consequences of this, such as limited financial resources and stress.

It is interesting to note that the characteristics of the sticker population are very similar to those of Australia’s public housing tenant population, but because public housing largely addresses affordability by rent capping, stickers are most likely to be private renters and low income mortgage holders.

This means that, in addition to being highly vulnerable, many stickers are likely to receive little or no government assistance with their housing costs. It also implies a pressing need to improve the supply and affordability of housing in the private sector – via the taxation system or the land supply system.

Rather than looking at housing affordability as one problem, the distinct differences observed between Australia’s slippers and stickers imply a need to focus particular attention and interventions on stickers. We also need to better understand how people enter and exit unaffordable housing and what we can do to prevent people becoming stuck.

In the bigger picture our findings describe real social inequalities in Australia that are present and persistent. It reminds us that the conversation we need to have about housing affordability in Australia isn’t just about the positives of “housing bubbles”, but also needs to be about how to address the serious affordability problems of the growing group of (often already vulnerable) Australians who are stuck.

By Emma Baker Reader in Housing at University of Adelaide and Rebecca Bentley Senior lecturer at University of Melbourne.

DFA Household Finance Confidence Index Up A Bit In May

The latest edition of the DFA Household Finance Confidence Index was released today. The latest data to end May shows there was an improvement over the last month, partly in response to the budget and the RBA rate cut, but the overall score is still well below a neutral setting. The score moved from 91.87 to 94.6.

The results are derived from our household surveys, averaged across Australia. We have 26,000 households in our sample at any one time. We include detailed questions covering various aspects of a household’s financial footprint. The index measures how households are feeling about their financial health.

To calculate the index we ask questions which cover a number of different dimensions. We start by asking households how confident they are feeling about their job security, whether their real income has risen or fallen in the past year, their view on their costs of living over the same period, whether they have increased their loans and other outstanding debts including credit cards and whether they are saving more than last year. Finally we ask about their overall change in net worth over the past 12 months – by net worth we mean net assets less outstanding debts.

Looking at the drivers of the index, for all Australia, we see that costs of living are rising, with 37.64% of households seeing a rise in the last 12 months (up from 37.2%), and more than half seeing no improvement in costs of living. Elements which are driving this include fuel costs, rising council charges and costs of imported goods.

Turning to income 3.8% of households have seen a real increase in the last year, compared with 5.5% last month. 39.9% of households have experienced a fall, compared with 38.4% last month, and 55.5% of households stayed the same compared with 55.8% last month.

Looking at household debt, 12.3% of households are comfortable with their debt levels, up from 11.4% last month. Households who are uncomfortable with their debt levels fell to 25.8% from 27.2% last month. The change was directly linked to the RBA Cash Rate cut in May, and an expectation that rates will fall further. Those with high credit card debts were significantly more likely to be is the less comfortable category. Those households with interest only mortgages were disproportionally more comfortable than those with a p&i loan.

Turning to savings, those who are more comfortable fell from 13.9% to 13.7%. We saw a rise in households who were less comfortable (from 30.4% to 30.9%) and more than half saw no change. One element of note was that households are tapping to their savings to fill the gap left by slow income growth, against costs and spending. Low deposit rates are encouraging some households to spend some of their savings.

On job security, there was a slight rise in those feeling more comfortable (from 16.2% to 16.8%). Interestingly those employment in small businesses saw a significantly larger positive swing, offset by lower levels of security in larger companies. The worst deterioration were in WA and QLD.

63.1% of households saw their net worth rising, up from 60.5% last month, thanks primarily to further rises in real estate (especially in Sydney and Melbourne) and shares. A slightly smaller proportion of households saw their net worth falling (down from 14.2% to 13.86%), the majority of those households who reported a fall were not property active, living in rented accommodation, and more reliant on Centrelink support than average. We also note a skew to rises in net worth in the main urban centres on the east coast, and higher than average income. Households in WA scored the highest fall this month.

So overall, we see the continuing trend of lower income, higher costs, those households with property and shares enjoying offsetting net worth growth, but others not participating to the same extent. The budget may have moved the dial a bit, but the RBA rate cut had more impact.

Note that this data is averaged across the states, though we note some significant differences between WA (overall confidence lower) and NSW (overall confidence higher), thanks mainly to differential movements in house prices and employment prospects. We do not published the detailed segment and state based analysis in this post. This detail is available to our paying clients!

Why Pensioners are Cruising Their Way Around Budget Changes – The Conversation

As reported in The Conversation: Age pensioners have always gone on cruises. But since the budget, we have seen stories emerge of age pensioners changing their behaviour in response to the proposed rebalancing of the age pension asset tests.

Sydney housewife Noelene has bought a holiday cruise to Alaska. Seemingly contradicting sensible living strategies for many older people, financial advisers are now proposing part-pensioners upsize and buy a more expensive house.

It’s surprising behaviour, especially in light of new research from CePAR using government data that demonstrates many age pensioners actually live very frugally. Many pensioners live below even the “modest” retirement standard proposed by ASFA ($23,469 for a single and $33,766 for a couple, who own their own home). Indeed, many pensioners are cautious and keep a cushion of assets, whether because of concern about risk, to pay for age care when frail, or to leave a bequest to children or grandchildren.

What’s changed

Why would age pensioners choose to spend big now? Well, it’s a rational response by part-pensioners to the proposed budget asset tests. If the anecdotal behaviour is writ large, a lot of the potential revenue gains (estimated at A$2.4 billion over 5 years) from the asset test changes may disappear.

Apart from the home, the financial and other assets of age pensioners are tested above a limit, so as to target the pension. The age pension is also subject to an income test. At the moment pensioners are assessed under both the income test and the asset test: whichever test gives the lower pension rate is applied. This allows considerable scope for sophisticated pension planning.

The 2015 budget includes changes to the age pension asset tests which deliver benefits at the low end but which are quite draconian for those who have accumulated some assets.

For homeowners, the asset free areas are to rise from $202,000 to $250,000 for single home owners and from $286,500 to $375,000 for couple home owners, but the asset test taper rate will double, from $1.50 per fortnight ($38 a year) per $1,000 to $3 per fortnight ($78 per year) per $1,000.

Pensioners who do not own their own home – and who are much less well off than those who own a home – will benefit from an increase in their threshold to $200,000 more than homeowner pensioners.

On a superficial view, these seem like reasonable changes. But they may have significant behavioural effects and there could be a better way to achieve the government’s policy goals.

Savings taxed: how the government is changing behaviour

The age pension can be thought of as a universal payment combined with an in-built income tax (the income test, which has a 50% tax rate up to the cut out point) and an in-built wealth tax (the asset test).

The effect of the change in policy is to reduce the asset cut-out point where the age pension ceases. Under current asset taper rules, the effective wealth tax rate in the asset test is 3.9% above the threshold. The budget proposal of a taper of $3 per fortnight per $1,000 implies a wealth tax rate of 7.8% ($78 per year per $1,000) above the new thresholds. With real returns of around 5% on many investments currently, the wealth tax effectively confiscates the whole of the real return above the thresholds.

A home-owner couple will see their pension cease at assets of $823,000 compared to over $1.1 million currently. But this home-owner couple with $823,000 in savings would not necessarily have a higher living standard than a home-owner couple with $375,000 in savings; indeed, it could well be lower.

Overall, under the proposed new system, income from savings would be very heavily taxed. Assuming a return to savings of 5%, the effective marginal tax rate could be as much as 160% (the wealth tax rate of 7.8% divided by a 5% return). This creates a disincentive to save. For the conservative investor the situation is even worse, as products like term deposits offer rates only slightly higher than inflation.

An alternative approach: deeming an income return

The Henry Tax Review and the Shepherd National Committee of Audit both recommended that the separate age pension asset test should be replaced by a comprehensive means test that deems income from assets.

A deeming approach disregards actual income from an asset. Only deemed income is included, based on a sensible choice of rate of return, such as the return on bank interest. At 1.75% and 3.25% rates, this is quite a conservative rate of return.

In fact, we already deem income returns in the current pension system, for assets including bank accounts, term deposits, shares, managed funds, loans to family members and superannuation funds (if you are age pension age).

Widening the deeming rules would return us to the “merged means test” which operated in Australia up to the 1970s. Under the test, all assets apart from the home were deemed to yield 10% per annum and actual income from assets was disregarded. The assumed yield on an annuity purchased at age 65 was 10%. Currently an indexed annuity at that age would yield around a third of that in real terms, and even a “growth” investment strategy will yield only 5% to 6%, so a deeming rate around 6% could be justified.

Deeming rates can be set to achieve the sort of budget savings sought by the government with fewer issues for fairness and perverse incentives. A deeming rate of, say, 6% combines with a pension taper of 50% to give an effective marginal wealth tax rate of 3%. This is much less than the effective 7.8% wealth tax rate in the budget measure.

Deeming allows a pensioner to have either modest income or modest assets but not both. It does not unfairly advantage those who maximise their entitlements by planning under both income and asset tests, as the current system allows. A wider deemed base could save as much at a lower effective wealth tax rate than that proposed by the government.

The bigger picture

Australia has highly generous tax concessions for retirement saving, but quite harsh treatment on the pension side. Why incentivise savings through super tax breaks and then penalise savers under the means test?

Home owner retirees are much better off than those who do not own their home and the age pension means test does not touch the top cohort of superannuation savers who receive a hugely disproportionate share of superannuation tax breaks. In contrast to most middle income savers who eventually need some level of age pension with its implicit wealth tax, the top cohort who don’t need the age pension are never subject to any wealth or bequests tax.

Why the Small Business Tax Break Could Pay for Itself

The immediate tax deduction for small business announced in the Federal Budget has been broadly welcomed, but what may have been missed is the fact that what the Government doesn’t collect now, it will collect later, according to The Conversation.

As part of the $5.5 billion small business package at the centre of its latest Budget, the Federal Government announced it would allow businesses with turnover less than $2 million to immediately deduct the cost of any individual asset purchased up to the value of $20,000, from Budget night through to the end of June 2017. The estimated cost of this accelerated depreciation measure to revenue is estimated at $1.75 billion over the four years of forward estimates.

But what should be noted about this measure is that it doesn’t change the eligibility for tax deductions of these assets; it simply changes how quickly a small business is able to receive the tax deduction.

Under the existing simplified depreciation rules for small business, an asset costing over $1000 would be depreciated at 15% for the first year, and 30% thereafter, until the taxable value of the asset pool is $1000 or less, at which point the full amount can be written off.

For a $20,000 asset, this would mean a $3,000 deduction would be allowable in the first year, and it would take around 10 years to fully depreciate it for tax purposes. This compares to a $20,000 deduction in the first year under the proposed measure.

Bear in mind, too, that small businesses fall into two general categories: those that are incorporated (companies), and those that aren’t (sole traders and partnerships). The taxable profits of small companies are taxed at a flat rate, which – assuming the announced 1.5% tax cut passes – will be 28.5%.

Unincorporated small businesses don’t get the 1.5% tax cut, as their income is included in the assessable income of the owners and taxed at their marginal rate of tax. Instead they’ll get a tax discount of 5% of business income up to $1000 a year.

Here, we’ll focus on small companies, where the flat rate of tax makes analysis easier.

For a small, incorporated business, and assuming the 28.5% tax rate, its tax bill would be reduced by $5,700 in the first year, as compared to only $855 under the existing regime. This is a total upfront benefit of $4,845, and supports the government’s argument that the change will improve cash flow for small business as compared to existing arrangements.

But the timing aspect also has a benefit for the Government, and there is evidence of this in the Budget Papers. Over the first three years of the forward estimates, the expected cost to revenue totals $1.9 billion. However, in the final year of the forward estimates (2018-19), this cost begins to reverse, and the Government expects to bring in an extra $150 million in revenue.

The reason for this reversal can be explained with respect to a hypothetical $20,000 asset purchased on July 1, 2015, by a small incorporated entity. Under the proposed rules, the company would have reduced its tax payable by $5,700 in the first year, as compared to only $855 under the existing rules.

This means the Government would collect $4,845 less tax from this company in respect of the 2015-16 tax year. However from the 2016-17 tax year onwards the Government will collect more, under the proposed measure, as this company has no further depreciation tax deductions available to it in respect to that asset.

This means that while over the forward estimates period, allowing this company to immediately deduct the cost of the asset in 2015-16 will cost the Government $1,662, it will subsequently collect $1,662 more in tax in the period beyond the forward estimates.

Mechanically, the total deduction for the asset under either the original simplified depreciation rules for small business or the proposed immediate write-off, will still be $20,000. In other words, whatever the Government doesn’t collect now it will collect later.

For the Government this is a good outcome politically for three reasons.

First, it allows it to say it is supporting small businesses to “have a go”, as Treasurer Joe Hockey puts it.

Second, even though there is a cost to revenue in the forward estimates period, over the following years this measure will have a positive impact on revenue. However, because this increase in revenue is primarily outside the forward estimates it is not visible in the Budget Papers.

This increase in revenue has to be equal to the cost – so the $1.75 billion net cost in the next four years will lead to an increase in revenue of $1.75 billion beyond the forward estimates.

Third, the Budget Papers contain only information on government decisions that involve changes since the previous Mid-Year Economic and Fiscal Outlook. So while this measure will mean the Government will collect more revenue over the years 2019-20 and onwards, this increase won’t register as a change in next year’s Budget and therefore this increase won’t be quantified there as such.

Payday Lending’s Online Revolution

Payday Lending has been subject to considerable regulation in recent years, but using data from our household survey’s and DFA’s economic modelling, today we look at expected trends, in the light of the rise on convenient online access to this form of funding.

We will focus on analysis of small amount loan – a loan of up to $2,000 that must be repaid between 16 days and 1 year. ‘Short term’ loans of $2,000 or less repayed in 15 days or less have been banned since 1 March 2013. These rules do not apply to loans offered by Authorised Deposit-taking Institutions (ADIs) such as banks, building societies and credit unions, or to continuing credit contracts such as credit cards. More detail are on ASIC’s Smart Money site.

The law requires credit providers to verify the financial situation of applicants, and to ask for evidence from documents like payslips or Centrelink statements, copies of bills, copies of other credit contracts or statements of accounts or property rental statements. The number of documents a lender asks for will depend on whether they have relationship data, credit history or bank statements. If households receive the majority (50% of more) of income from Centrelink, the repayments on the small amount loan (including any other small amount loans held) must not exceed 20% of income. If they do, potential applicants will not qualify for a small amount loan.

From 1 July 2013, the fees and charges on a small amount loan have been capped. While the exact fee will vary depending on the amount of money borrowed, credit providers are only allowed to charge a one-off establishment fee of 20% of the amount loaned, a monthly account keeping fee of 4% of the amount loaned, a government fee or charge,default fees or charges and enforcement expenses. Credit providers are not allowed to charge interest on the loan. This cap on fees does not apply to loans offered by ADIs such as banks, building societies or credit unions.

DFA covered payday lending in a recent post, and ASIC has been highlighting a range of regulatory and compliance issues.

So, we begin our analysis with an estimation of the size of the market, and the proportion of loans originated online. The value of small loans made has been rising, and we now estimate the market to be more than $1bn per annum. We expect this to rise, and in our forward modelling we expect the market to grow to close to $2bn by 2018 in the current economic and regulatory context.

One of the main drivers of this expected lift is the rise in the number of online players, and the rising penetration of online devices used by consumers. Today, we estimate from our surveys about 40% of loans are online originated. We estimate that by 2018, more than 85% of all small loans will be originated online. As we highlighted in our previous post, the concept of instant application, and fast settlement is very compelling for some households.

The DFA segmentation for payday households identifies two discrete segments. The first, which we call disadvantaged are households who are likely to be frequent users of small amount loans, often on Centrelink benefits, are socially disadvantaged, and with poor work history. The second segment is one which we call inconvenienced. These households are more likely to be in employment, but for various reasons are in a short term cash crisis. This may be because of unexpected bills, illness, unemployment, or some other external factor. They may even borrow for a holiday or family event such as wedding or funeral. They are less likely to be serial borrowers.

We see that both segments are tending to use online tools to seek a loan and may also be accessing other credit facilities. Our prediction is that by 2018, of the total of all small loans applied for, more than 35% will be applied for by disadvantaged, and 45% by inconvenienced via online. Together this means that as many as 90% of loans could be be sourced online. More than three quarters of these applications will be via a smart phone or tablet. As a result the average age of a small loan applicant is dropping, and we expect this to continue in coming years. This helps to explain the rise on TV and radio advertising, directing households with financial needs direct to a web site. Phone based origination, as a result is on the decline. We estimate there are more than 100 online credit providers in the market, comprising both local and international players. Online services means the credit providers are able to access the national market, whereas historically, many short terms loans were made locally by local providers, face to face. This is a significant and disruptive transformation.

We finally look at the segment splits in terms of number of households using these loans. We note a significant rise in the number of inconvenienced households, to the point where by 2018, about half will be this segment. This is because the rules have been tightened for disadvantaged households, and online penetration for inconvenienced is higher.