You’ve probably noticed that many commentators in the media are convinced that there will definitely be an Australian property crash. There have also been a few suggested catalysts for this terrible eventuality.
Recently, Interest only loans have been in the spotlight as ASIC has voiced concerns on the quantity of these loans being originated through mortgage brokers. It is implied that brokers are wilfully putting borrowers at risk and the fear is that there could be an Australian property crash, similar to the calamitous events in the USA ten years ago.
So, let’s look at two big questions here:
- Why are interest only loans so dangerous to our banking system?
- Why would mortgage brokers wilfully put our economy at risk by recommending these products?
Firstly, interest only loans have lower repayments, as paying down any principal amount isn’t mandatory. These loans typically have a term of 5 years, where they then convert to principal and interest repayments (P&I) which can then be substantially higher.
The fear amongst financial observers is that each interest only loan is a potential time bomb, because it’s assumed that the borrower may not be able to afford to increase their mortgage payments, or to refinance to another interest only loan at the 5 year mark, meaning the higher principal and interest repayments will not be met.
There is no doubt that an Australian Property Crash could eventuate following a sudden large increase in loan repayments for all borrowers, triggering severe mortgage stress.
This would be more likely to occur after a rapid rise in the RBA cash interest rate combined with high unemployment. An unlikely event, but still possible.
However, the perceived problems with interest only loans is a different issue. These Interest only loan products have been around for a long time, as they offer borrowers flexibility and tax efficiency, particularly if they are used for investment purposes. A problem arises with tax efficiency if everyone is forced into using P&I loans for investment purposes.
The concern that mortgage brokers recommend a larger volume of interest only loans is easy to explain, because it correlates closely with the market share of all loans written by brokers anyway. In other words, the percentage of interest only loans written by brokers is the same as their market share of all loans written.
The fact is, compared to internal bank staff, mortgage brokers are much more likely to explain the function of these products and recommend a wider range of loan options to fit in with the client’s long-term goals.
Here’s a typical scenario where interest only lending makes sense:
It’s common logic to pay off a principal place of residence home loan – as it’s not tax deductible – and just pay the interest only component on any investment loans you have. When you finally have no personal debt, you could then focus on paying down the investment loans.
It’s a common misconception that interest only loans are never paid down, but did you know that most interest only loans have no restriction on how much you can pay off unless the loan is fixed?
In fact, an interest only loan, combined with an offset account, can be an extremely effective financial product for money management if used correctly. Many people, especially in the media, aren’t aware of this, which highlights the important role of mortgage brokers in educating borrowers.
There is little doubt that the regulators are concerned about financially illiterate (and irresponsible) borrowers in their current crackdown on interest only loans. Certainly, their restriction on owner occupied lending in this segment has merit as a responsible lending measure.
The intervention by APRA in the last two years has definitely resulted in tighter lending guidelines from the banks, especially with investment lending. Currently rates on interest only loans are around 0.5%+ higher than standard principal & interest (P&I) loans, and overall volumes in this loan category have fallen this year for the first time since 2009.
Make no mistake, if you apply for an interest only loan these days, lenders will assess you using tough serviceability criteria.
Typically, you will be stress tested on principal and interest repayments at interest rates up to 3% higher than current retail levels to ensure you can afford the interest only loan when it reverts to P&I in 5 years.
Have they gone too far? Maybe. Was there even a big problem with these loans in the first place? It’s hard to tell, however we’re confident that the current market exposure of interest only loans won’t be the cause of an Australian housing crash.