Why more Aussies are getting trapped in a 'mortgage prison'

As property prices continue to drop across Australia and interest rates trend upwards, some borrowers are finding themselves trapped in their current mortgages with no way out.

It's estimated the median house price in Sydney could drop by more than $175,000 by the end of 2023 while in Melbourne it could fall by more than $156,000, according to NAB forecasts.

This could trap new homebuyers with smaller deposits in a sticky situation, known as a mortgage prison, as the property market slumps.

Here we unpack what a mortgage prisoner is and how to get out if you are trapped.

EXPLAINED: Why are Australia's interest rates still rising?

What is a mortgage prisoner?

Mortgage prisoner is the apt term for a borrower trapped in their current mortgage who is unable to refinance their loan.

There can be a mix of factors leading to a borrower becoming trapped in their current loan including their home declining in value, interest rate hikes, or income changes.

Finance Brokers Association Australia director Peter White said banks assess a borrower's "serviceability" or how much you can afford to pay at a different rate.

For example, interest rates could sit at 5 per cent but the lender will look at your ability to pay up to 8 per cent.

Not only are the current interest rate rises driving more people into the trap but White said banks have "the nasty habit of repricing the back book".

"They look at existing customers and put their home loan rate 0.45 to 0.7 per cent above what other people are paying," White said.

This means people who are already in a mortgage prison become even further entrapped and White warned more and more people are getting stuck.

Why are more people becoming mortgage prisoners?

Interest rate rises are the common denominator for property prices falling and therefore more people getting trapped in their home loans.

The Reserve Bank of Australia has hiked interest rates six times consecutively. The cash rate now sits at 2.60 per cent as an attempt from the central bank to settle spiralling inflation.

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So now with interest rates expected to continue to rise and property prices continuing to drop, more borrowers' loan-to-value ratios will be pushed out.

The loan-to-value ratio refers to the value of a home compared to the amount of money borrowed on a home loan.

For borrowers with a small deposit, if the value of their house declines and their equity (or more simply, how much of the house they own) falls below 20 per cent then the loan-to-value ratio could change.

The higher the loan-to-value ratio means the borrower becomes a higher risk and the lender is less inclined to allow them to refinance their loan.

"They are likely to have to pay lenders mortgage insurance, a cost that can run into the tens of thousands of dollars and could easily negate savings made from refinancing," RateCity.com.au said.

"In some cases, lenders might decide not to take them on at all due to their equity position."

Why are property prices falling?

Basically, as interest rates rise, mortgages become more expensive.

People will have less of the bank's money to spend and will compete for cheaper properties meaning the market needs to match that - equalling a property price drop.

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NAB forecasts that property prices will decline by 20 per cent across Australia's capital cities and the RBA is set to hike the cash rate again.

"Every time the RBA hikes rates, the maximum amount people can borrow from the bank takes a hit, and with a number of rate hikes potentially waiting in the wings, the drops in property prices are likely to continue," RateCity.com.au research director Sally Tindall said.

"In the boom, a 'fear of missing out' drove property prices higher. Now a 'fear of getting in', is having the reverse effect.

Will interest rates keep rising?

Short answer - yes.

The RBA is still trying to battle inflation and says it will "do what is necessary to achieve that", which means more interest rate hikes are on the horizon but by how much is not yet known.

"The size and timing of future interest rate increases will continue to be determined by the incoming data and the Board's assessment of the outlook for inflation and the labour market," governor Philip Lowe said after the latest hike.

White predicts interest rates will rise another 75 basis points up to 3.35 per cent meaning home loans will hit around 5 per cent.

With the continual rises and property prices fluctuating, White added borrowers can get "trapped very quickly" if they're not aware.

So, what do you do to avoid becoming a mortgage prisoner and what do you do if you are?

Tindall said anyone stuck in a mortgage prison should still be negotiating with their lender for a better rate on their loan.

"This will help them make their monthly repayments, and potentially extra so they can break out of mortgage prison faster."

White said fixing your rate is an option to keep the future secure for a while which is what some borrowers did during the pandemic while interest rates remained low.

Otherwise, White recommended "just riding the wave" through the rate hikes but most importantly he said to seek independent financial advice from a mortgage broker as there is no one size fits all answer.

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"There is no easy answer to this. It's about getting the best guidance you can and working out the best outcome," he said.

"You need to look very critically and in detail about your circumstances and what you want to do, for example renovating, going on a big holiday, buying a new car, all those things you need to weigh up.

"That's where getting a professional to help is important."

The information provided on this website is general in nature only and does not constitute personal financial advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information on this website you should consider the appropriateness of the information having regard to your objectives, financial situation and needs.