‘Interest-only’ loan rush signals coming of a new phase

As property valuations get stretched the sharemarket looks a better option.

Healthy returns in the next few years for the average investor entering the apartment market are fading rapidly.

About two years ago, I applied for a mortgage for an investment property and to my surprise they told me: “If you like you can make this interest-only … you won’t have to pay off the principal.”

Since I was fixing this loan for three years, I was puzzled for a moment at this offer to defer paying off the principal for years into the future.

And then I said: “Well, sure, let’s do that. I mean, why not? ”

But here’s the thing: I thought this was a reward, a prize if you like, for my years of being a faithful client of this “big four” bank.

Moreover, since I’m in the ­finance media, I was pretty sure I’d got into a sort of club. I recalled that interest-only loans were a very small segment of the market.

Wrong! This week it was ­revealed that 40 per cent of all new mortgages — and a whopping 60 per cent of investor mortgages — are interest-only.

What’s more, the level of interest-only loans in the system has doubled in three years.

Crikey! I’m not in a minority, I’m in the majority — me and a horde of interest-only borrowers are now threatening the very market I’ve geared myself into.

Interest-only loans are not ­inher­ently dangerous — they will make sense to well-financed ­inves­tors. But with 60 per cent of investors using them and a scary 20 per cent of owner-occupiers using them, the risks to the system are ­indisputable.

Now, there is always money to be made by someone somewhere in the property market — no doubt there are bargains in Perth and in selected mining towns. Wily investors will, for sure, make the occasional killing in “mezzanine” finance as developers race to finish apartment towers before the expected crunch in the inner-city market comes to pass.

But for the average investor entering the apartment market now (the traditional “first step” in property), the chances of getting healthy returns in the next few years are fading rapidly.

The mushrooming of interest-only loans is just another sign the market has moved into a “bubble” phase. The banks are being leaned on by all regulators to cool lending; lending rates are going up and steadily the supply of new apartments into the market is expected to at best flatten ­prices.

Of course, the tax benefits of negative gearing and capital gains tax allowances remain in place, but there is a very strong chance the government will lessen these privileges soon — it is rumoured, for example, that the government may reduce the capital gains tax discount you get after holding an asset for more than a year from 50 per cent to 40 per cent. This could be included in a wider package of measures to be ­announced in the federal budget on May 9.

Shares attractive

Meanwhile, in contrast, the sharemarket is looking attractive. The returns — from both a price perspective and an income dimen­sion — are healthy and the prospects are certainly more ­reliable than residential property.

Separately, while investors in the property market are heavily mortgaged, very few private ­investors in the sharemarket take advantage of negative gearing. In fact, many people don’t realise negative gearing is not a “property only” tax shelter; it can be used for shares or managed funds as well.

We see so much attention paid to the Sydney residential market’s 19 per cent annual returns, but the portion of Australians who can ­access this market is limited; the sharemarket, on the other hand, has entry prices starting at $500 — the value of a minimum block of shares.

Better still, the strong returns in the sharemarket are available to everyone … wherever they live.

Don Hamson, the managing director of the Plato Investment Group, puts it this way: “We have a very reliable dividend stream in the market and it has meant total returns are more predictable than many investors might expect. It’s really when you work in the after-tax value of franked dividends that you see the full picture.”

Tracking back to 2011, when Hamson started his Plato Australian Shares Income Fund, the local market has offered a total ­average return a year of 12 per cent (including franking) — underpinning those returns has been a dividend yield of about 4.5 per cent that when “grossed up” — in other words, when the after-tax benefits of franking are taken into account — reaches about 6 per cent. So the sharemarket has been pumping out returns of 12 per cent each year, and half of that return is as reliable dividend payments.

As a fund manager, Hamson has had to clear a high hurdle to offer an above-average return but he has managed to get 14 per cent a year (after fees) through skilled use of buying high-dividend paying stocks, especially as they near the dividend payment date when they reach seasonal peaks.

Hamson is comfortable the patterns set in the past six years are sustainable — he can, of course, say such things knowing the local market is still well behind where it was 10 years ago — in mid-2007, the ASX was surging towards a peak of 6800. You have to doubt a property expert could offer a similar outlook.