Default fears on interest-only loans

A crackdown on interest-only loans is set to cause unprecedented problems for residential property investors.

An auction in Melbourne: Pic: Aaron Francis

A crackdown on interest-only loans across the housing industry is set to cause unprecedented problems for a new generation of residential property investors already facing higher interest rates than owner-occupiers.

The major banks split their lending rates into separate prices for owner-occupiers and investors.

In the last six months each of the bigger banks has “repriced” their investor loans so that investors now pay more than owner-occupiers.

“The effects of these higher costs for investor-only loans will almost certainly now be made starker,” says Michael Saadat, a senior executive leader at consumer regulator ASIC, which has warned it is now targeting credit quality standards in the interest-only sector.

ASIC’s efforts are planned to coincide with a new rule from the prudential regulator APRA which means banks will have to pull back their current level of interest-only loans from 40 per cent of new business to 30 per cent.

It is estimated that inside the banking system the actual level of interest-only loans held by the investor segment is closer to 60 per cent — a level that would be among the highest in the world.

Worse still, a growing number of investors have been taking out interest-only loans which are fixed rate. Regulators are concerned these borrowers will soon face a double bind.

First, they may not be able to get another interest-free loan when their current loan expires.

Second, because their fixed term has expired the rate payment on the loan will be much higher than the original rate.

The looming pressure building on interest-only investors is emerging as the outstanding risk in the home lending market.

Yet it has been allowed to develop remarkably fast. The percentage of interest-only loans across the banking system was just 20 per cent three years ago.

Top end financial advisers continue to recommend interest-only mortgages to high income earners as a way to both minimise tax and underpin long term investments in the property market.

With record low interest rates in recent years advisers have also been recommending fixed interest loans on an interest-only basis as a useful strategy.

Until very recently the major banks have been more than willing to offer finance on interest-only terms.

Indeed Jon Sutton, chief executive of regional lender Bank of Queensland, has suggested his bank is no longer willing to chase the same clients as the “big four” banks, which are regularly coming over the top and offering ever bigger mortgages to clients.

Some advisers suggest interest-only loans allow high income earners to benefit even if house prices are showing little or no growth — such as in Brisbane or Perth at present — because investors can still get personal tax deductions from negative gearing. At its best the strategy can be very rewarding in strong markets such as Sydney and Melbourne, where prices are rising rapidly.

However, regulators are clearly worried the fashion for interest-only arrangements — once reserved for very wealthy clients — will create much higher default problems than the banking system has witnessed in the past, when mortgage repayment levels have been traditionally reliable.