DFA analysis shows that over the next few years a considerable number of interest only loans (IO) which come up for review, will fail current underwriting standards. So households will be forced to switch to more expensive P&I loans, assuming they find a lender, or even sell. The same drama played out in the UK a couple of years ago when they brought in tighter restrictions on IO loans. The value of loans is significant. And may be understated, according to new research.
A few observations. ASIC in 2015, released a report that found lenders providing interest-only mortgages needed to lift their standards to meet important consumer protection laws. They identified a number of issues relating to bank underwriting practices. We would also make the point that despite the low losses on interest-only loans to date in Australia, in a downturn they are more vulnerable to credit loss.
In April this year we addressed the problem of IO loans.
Lenders need to throttle back new interest only loans. But this raises an important question. What happens when existing IO loans are refinanced?
Less than half of current borrowers have complete plans as to how to repay the principle amount.
Interest-only loans may seem like a convenient way to reduce monthly repayments, (and keep the interest charges as high as possible as a tax hedge), but at some time the chickens have to come home to roost, and the capital amount will need to be repaid.
Many loans are set on an interest-only basis for a set 5 year term, at which point the lender is required to reassess the loan and to determine whether it should be rolled on the same basis. Indeed the recent APRA guidelines contained some explicit guidance:
For interest-only loans, APRA expects ADIs to assess the ability of the borrower to meet future repayments on a principal and interest basis for the specific term over which the principal and interest repayments apply, excluding the interest-only period
We concluded:
This is important because the number of interest-only loans is rising again. Here is APRA data showing that about one quarter of all loans on the books of the banks are interest-only, and that recently, after a fall, the number of new interest-only loans is on the rise – around 35% – from a peak of 40% in mid 2015. There is a strong correlation between interest-only and investment mortgages, so they tend to grow together. Worth reading the recent ASIC commentary on broker originated interest-only loans.
But if households are not aware they have IO loans in the first place, then this raises the systemic risks to a whole new level. The findings from the follow-up study by UBS, after their “Liar-Loans” report (using their online survey of 907 Australians who recently took out a mortgage – they claim a sampling error of just +/-3.18% at a 95% confidence level) are significant.
They say their survey showed that only 23.9% of respondents (by value) took out an interest only loan in the last twelve months. This compares to APRA statistics which showed that 35.3% of loan approvals in the year to June were interest only.
They believe the most likely explanation for the lack of respondents
indicating they have IO mortgages is that many customers may be
unaware that they have taken out an interest only mortgage. In fact, around 1/3 of interest only borrowers do not know that they have this style of mortgage.
Source: UBS
They also says 71% of respondents who took out an interest only mortgage during the last 12 months indicated they are already under moderate to high levels of financial stress.
Source: UBS
Finally, they found that Interest Only borrowers via the broker channel are more likely to be under high financial stress from recent rate rises.
