Why doesn’t inflation include your mortgage interest?

The Consumer Price Index (CPI) tracks changes in the prices of goods and services households buy. The percentage change in CPI is the measure used for Australia’s headline inflation rate.

However, tracking consumer prices is different from tracking all the money households need to pay their bills. CPI measures mortgage borrowers’ housing costs through new dwelling prices, rather than the interest they pay on their loans. The ABS measures mortgage interest separately through its Living Cost Indexes.

To understand the distinction, consider a simpler purchase. A fridge’s price rises from $1,000 to $1,100. That is a 10% price increase, whether the customer pays from savings or borrows the money.

Now suppose two customers buy the fridge for $1,100. One pays upfront. The other uses a loan and pays interest as well. Both pay the same price for the fridge, but the borrower pays an additional cost to finance it.

CPI tracks the price of the purchase. It does not add the buyer’s interest bill to that price.

Housing requires a more detailed approach because a home combines a place to live, an asset and, often, a long-term loan. The ABS must decide which parts represent consumer purchases and which represent investment or financing. Its housing methodology explains how it makes those distinctions.

CPI includes housing, but it does not use mortgage repayments or property sale prices as a general measure of housing inflation.

For tenants, the approach is relatively straightforward: the ABS tracks rents paid.

If your rent increases from $600 to $630 a week, you pay 5% more for the housing service. Rent changes contribute to CPI, although the national figure combines many rental properties and will not necessarily match your lease increase.

For owner-occupiers, the ABS tracks new dwelling prices, excluding land. This captures changes in the cost of the dwelling, including building materials, labour and builder margins.

Suppose a builder charges $400,000 to construct a particular house, excluding land. A year later, the same house costs $420,000 to build. That 5% increase contributes to the new dwelling component of CPI.

The ABS also includes other housing expenses, such as maintenance, rates and utilities. Owning an existing home therefore does not mean all your housing costs sit outside the index.

Land can provide a location for a home, but it also holds value as an asset. The ABS treats its purchase as investment rather than consumption.

If a block becomes more expensive while the price of constructing a house stays unchanged, buying the completed property may become harder. However, the land price increase does not directly enter CPI.

Existing homes receive different treatment from newly built homes because they generally move between households. One household buys what another household sells. The transaction changes who owns the property, rather than adding a dwelling to the household sector.

For example, when you buy an established home from another owner, your purchase is also their sale. When a household buys a newly built dwelling from a developer, the household sector acquires an additional dwelling.

This is why CPI can include new dwellings while excluding established-home purchase prices. It is also why CPI cannot tell you how quickly the price of entering the property market is changing.

Mortgage interest measures the cost of borrowing. It can change independently of the price of the home.

Imagine two households buying identical homes at the same price. One borrows $300,000 and the other borrows $600,000. At the same interest rate, the second household pays twice as much interest on those balances.

Their interest bills differ because they borrowed different amounts. The dwellings did not cost different amounts.

Interest costs can also increase after the purchase, without any change in what the household owns. A borrower may still live in the same home and owe a similar balance, but pay more interest because their variable rate has risen.

That increase is real financial pressure. It answers the question, “How much does servicing this debt cost?” rather than, “How has the purchase price changed?”

Australia’s CPI approach separates those questions. It measures new dwelling prices as part of consumer-price inflation and captures mortgage interest in the Living Cost Indexes.

The RBA uses interest rates to influence spending and inflation. Including mortgage interest in CPI would mean that changing rates directly changes the inflation measure itself.

After a rate increase, higher mortgage interest would push CPI up, even before the policy had time to slow spending. After a rate cut, lower interest would pull CPI down, even if other consumer prices had not changed.

The ABS identifies this circular relationship as a reason for excluding mortgage interest from the measure used for inflation targeting. Its current approach to owner-occupied housing has operated since 1998.

The ABS’s Selected Living Cost Indexes examine changes in the expenses households pay to maintain their standard of living. They include mortgage interest.

This makes them useful for a different question: how are changing costs affecting the money households need to meet their expenses?

They do not simply add the full mortgage repayment to CPI. Principal and interest serve different purposes, and the indexes treat them differently.

Suppose your monthly repayment is $3,500, consisting of $2,700 in interest and $800 in principal. The interest pays for borrowing the money. The principal reduces your debt.

You need enough cash to cover both. However, the Living Cost Indexes include the mortgage interest component, rather than treating debt repayment as a consumption expense.

Likewise, choosing to pay an extra $500 off your loan reduces the cash available for other spending. But that voluntary payment does not mean your cost of living has increased. You have chosen to reduce your debt faster.

The distinction helps separate changes in living costs from other reasons money leaves your account.

Households spend their money differently. A price increase has a greater effect on a household that devotes more of its budget to that expense.

The ABS therefore produces separate indexes for employee households, age pensioners, other government payment recipients and self-funded retirees. Each gives different importance to expenses according to that group’s spending pattern.

For instance, a working couple with a large mortgage may feel an interest-rate increase strongly. A retired couple who own their home outright will not face that additional interest bill, but rising health costs could put more pressure on their budget.

Even households within the same group can have different experiences. Two employee households may earn similar incomes, but one rents while the other has a mortgage. A rent increase affects one directly; a mortgage-rate increase affects the other.

The employee Living Cost Index combines spending across that household group. It does not represent only mortgage borrowers, and its percentage change will not match every employee household’s expenses.

The Living Cost Indexes help show how expenses such as mortgage interest affect household budgets. CPI serves a different purpose: tracking consumer-price inflation.

The immediate effect on a borrower and the later effect on inflation happen through different stages.

First, higher rates can increase loan repayments. Affected households then have less money available for other spending, unless their income rises or they draw on savings.

Suppose your repayment increases by $150 a month. You might postpone buying furniture or reduce spending on meals out. Your mortgage costs have increased, but businesses elsewhere receive less of your money.

Higher rates also make new borrowing more expensive. A business considering equipment may delay the purchase because financing costs have risen. If customer demand also weakens, it may become more cautious about expanding.

When enough households and businesses make these adjustments, demand grows more slowly. Businesses may find it harder to increase prices without losing sales. This can help slow inflation over time.

The process is gradual. Some borrowers have fixed rates, some households have little debt, and some businesses can fund investment without borrowing. Higher rates therefore do not affect everyone at the same time or with the same force.

They also cannot immediately resolve supply shortages. Higher borrowing costs do not produce more fuel or train additional construction workers. They can, however, restrain spending while those pressures persist. The RBA explains these channels in its guide to interest rates and inflation.

For borrowers, higher mortgage costs can therefore squeeze the household budget while helping slow price growth across the economy.

The first step is to identify the question the report answers.

CPI helps explain how consumer prices are changing. A Living Cost Index helps explain changes in expenses for a particular household group. Neither measures how affordable life is for you without also considering your income and circumstances.

Check whether prices are rising more slowly or falling

A lower inflation rate usually means prices are still increasing, but at a slower pace.

Suppose a basket costs $100. A 4% increase takes it to $104. A further 3% increase takes it to $107.12.

Inflation has slowed from 4% to 3%, but the earlier increase remains in the price. Households need income growth, lower expenses elsewhere or other adjustments to regain that lost spending power.

A price fall is different. If the basket drops from $104 to $102, it has become cheaper over that period. Even then, it still costs more than the original $100.

Check the period before comparing figures

Annual inflation compares prices with a year earlier. A monthly or quarterly change measures a shorter period.

A falling annual rate does not necessarily mean price pressure eased in the latest month. A large increase from a year ago may have dropped out of the annual comparison, while prices continued rising recently.

The reporting period also determines which events the figures can capture. A June-quarter report cannot show the effect of a September mortgage-rate increase, even if you read it after that increase occurred.

Look at the drivers, then consider your own spending

The headline combines many price changes. The detail shows which expenses contributed most.

If cheaper petrol helps slow inflation, a household that drives frequently may notice relief. Someone who rarely drives may benefit much less.

Similarly, a rent increase can put pressure on a tenant while leaving an outright homeowner’s housing payments unchanged. Both may still face rising insurance or electricity costs.

The report helps you understand the wider pattern. Your own income, bills and loan commitments explain what that pattern means for your budget.