Interest-only crisis time bomb ticking as repayments reset

At their peak, 60 per cent of investment borrowers were paying only the interest off their debt. Now they’re in for a rude shock.

Investors with interest-only loans face a big rise in payments

The trouble in the interest-only loan market is unique: we know it is going to happen, we know the numbers, and crucially, we know the regulators made a big mistake allowing the seeds to be planted in the past three years.

The question now is how will it play out.

To recap: interest only loans where you pay no principal and just interest for a fixed period made up less than 20 per cent of the total market for many years, but then between 2014 and 2017 they swelled beyond any forecasts.

Though the bank regulator finally moved to restrict the loans last March, they remain about 27 per cent of all loans on the books of the major banks.

At their peak around a year ago 60 per cent of new investment loans and a worrying 20 per cent of new owner-occupier loans were given out interest-only by the banks

Early this year the Reserve Bank flagged concerns about how investors were going to handle the natural termination of these loans in the years ahead.

Interest-only investors have been paying an artificially low amount on their loans — traditional principal and interest arrangements work out at roughly double interest-only arrangements.

The situation is all the more concerning because roughly one-third of all investor loans are on a fixed rate basis.

Some of those loans have terms as short as three years some, which means the problem will start to surface in mid-2018.

No wonder APRA this week reiterated it has no plans to change its ruling, which restricts banks to keeping interest-only lending at less than 30 per cent of all loans. “We want to see where it settles,” APRA boss Wayne Byres told a Senate committee on Thursday.

Why did investors rush into interest-only loans — especially at fixed rates? The simple answer is because at the time investors perceived that rates were at cyclical lows (which turned out to be correct) and many were being offered these products for the first time.

‘‘Back then fixed rates were often cheaper than variable rates, so they were inevitably popular, especially with wealthier investors who had multiple properties,’’ says Martin North of Digital Finance Analytics.

WEB Wealth Interest only home loans

For these investors the issue is going to be acute because when the term of their interest-only loans end they will also face higher rates. Perhaps facing higher rates after a few years should have been expected, but at this stage in the investment cycle there are two underlying issues that make it much more difficult than might have been expected.

• First, house prices are softening across most capital cities — the latest monthly figures for February again show price reductions in almost every city, especially Sydney. For investors who went interest-only relying exclusively on a capital gain, the outcome is uncertain.

• Second, rental yields have virtually stalled — in the larger cities they appear stuck firmly at around 3 per cent gross, while rates in regional centres range higher between 4 and 5 per cent.

A desperate scenario

The problem with interest-only loans is that they delay the inevitable. When an interest-only loan agreement ends, if the borrower moves to principal and interest (which may be required if they the bank does not extend the deal) then along with automatically higher repayments the borrower will almost certainly face higher ongoing interest rates.

It’s a double hit.

This may be a deal-breaker for many investors, because coupled with higher costs, there is virtually no rental growth. Put simply, if investors can’t raise the cash elsewhere then a desperate scenario emerges where forced sellers arrive on the market all at the same time.

And the risk a bank will not roll over a loan as interest-only is high — the regulator APRA may loosen overall lending restrictions, but as mentioned earlier, interest-only restrictions will stay in place.

In fact, in the latest half-year results it was clear the banks were pulling back from the market in dramatic fashion — ANZ, for example, issued only 14 per cent of its mortgage book as interest-only loans in the most recent quarter.

And just to make it all a little harder, most banks have recently split their lines of business between owner-occupier and investor, who until recently had been charged the same rate. Now most banks have a special investor rate which is up to 0.8 per cent on top of the standard variable rate. (Financial adviser James Gerrard says interest-only loans are now so expensive they may no longer be worth using — see below.

What to do? Interest-only loans just now look like a ticking time bomb for the stretched property investor.

The worst outcome would be selling property in order to raise cash to meet repayments — especially if the market remains as soft as is at present.

Facing up to the full cost of the loan may be the right thing to do from a prudential perspective but that too will be tricky for investors where cashflows are managed tightly.

One option that could be explored is the extension of the interest-only loans — but then again all the signs are that banks are going to continue to keep a tight lid on this line of business in the near future.

Some advisers have been suggesting the non-banks, which are not as stretched with legacy interest-only loans on their books, may offer a window to investors.

None of these choices are ideal — but then again, the investors took the risk knowing what they were facing ... or did they?