Interest-only property loans spell trouble ahead

The interest-only mortgage business is running hot and the rise in looser lending is going to bring trouble.

Perhaps the single biggest unexamined issue in the residential property market is the swing towards interest-only home loans.

As the wider market endlessly examines surging Sydney prices, plunging values in mining towns and the never-ending comparisons with overseas markets, four out of every 10 new home loans across the nation go to people who have generally no intention of paying out their mortgages.

There have always been interest-only loans but they were for very rich investors. Today they are available to just about anyone. In fact, they are being made available to many who clearly have not been properly assessed by lenders (more on that later).

The interest-only mortgage business is growing at 20 per cent a year — that’s about eight times faster than our GDP growth and should make it plain just how “hot” this lending sector has ­become.

From a macro-perspective it’s patently obvious that this rise in looser lending is going to bring trouble sooner or later. But that day it seems is still some way off, sufficiently far away to consider the investment proposal offered by interest-only home loans. As my colleague, the economist Adam Carr has suggested more than once: the annual cries of an impending property crash continually fail to materialise. Moreover, while we have a shortage of housing, low interest rates and we come to terms with recent population rises, there is little evidence now that any significant housing downturn is looming.

Indeed a close look at the delinquency rates in the interest-only home loan sector shows they are currently lower than delinquency rates in the traditional “interest and principal payment” sector. But the troubling aspect of this quiet surge in interest-only loans is the manner in which it is being handled by the banks.

ASIC, led by chief executive Greg Medcraft, had this to say earlier this week following a two-year review of the sector:

1. In more than 30 per cent of the files examined there was no evidence the banker had considered whether the interest-only loan met the borrower’s requirements.

2. In 40 per cent of the cases the clients were given an underestimation on the length of time the lending would last.

3. In one in five cases the ­borrower’s actual living expenses were not considered.

So, as an investor the picture is clear — if you want an interest-only loan, it is not hard to get one. But do not in any way trust a bank to look after your interests or give you advice — it is very obvious banks are regularly just signing people up for these loans without sufficient examination of their circumstances.

Separately, the realities of an interest-only loan must be examined.

The clear advantage of these loans is that you can maximise your exposure to rising property prices. You can also minimise your outgoings in relation to a property investment. From a tax perspective you can improve your negative gearing.

The disadvantages are that with rental yields between 3 per cent and 4 per cent — and mortgage rates in the 4 per cent range — you are depending very heavily on price improvement to make it all work.

You will also have to pay a lot more to service these loans than standard loans once the “interest-free” period ends, which is five years on average. Remember, that though you may have started with the idea of never having to pay any principal ... it might not work out that way.

To put it plainly, if you don’t get that price rise in the first five years you invariably have big ­repayments coming down the line — that’s when you’ll know if it all worked out. This is not an area for inexperienced investors.

Just like hedge funds or peer-to-peer lenders (see today’s article from Elizabeth Redman) deregulation has made these often exotic products widely available, but that certainly does not mean everyone should jump on board.

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