Interest Only Loans – Page 4 – Digital Finance Analytics (DFA) Blog

Interest Only Loans Decline Significantly To Sep 2017

The latest APRA Property Exposure Data to September 2017 has been released. The most significant change is in the relative volume of interest only loans now held in the portfolio.

First, note that the average loan balance for interest only loans currently stands at $347,000 against the average balance of $264,000. So further confirmation that interest only loans are on average larger. No surprise of course, as these loans do not contain any capital repayments (hence the inherent risks involved, especially in a falling market).

Then look at the relative share of interest only loans in the portfolio, as households switch to more expensive principal and repayment loans (meaning their monthly repayment just went up!). In addition, see the mix of loan value versus volume. Interest only loans have fallen from around 40% in total value to 35%, but this represents a fall from around 30% of the loan count, to 27%. This again reflecting the higher average loan values for IO borrowers.

We also see a fall in the volume of investment loans being held on book. As the lions share of interest only lending has been for investment purposes, this is of no surprise.

We will look at the data by individual type of lender in a separate post, together with the latest loan to value splits.

Brokers ‘not recording the outcomes’ of IO discussions: ASIC

From The Adviser.

Brokers may be having the appropriate conversation with borrowers on interest-only home loans, the financial services regulator has said, but there has been some “pretty poor record keeping”.

The financial services regulator announced last week that it would “shortly” begin reviewing the loan files of brokers with a “high proportion of interest-only loans” as part of its work “to ensure that consumers are not paying for more expensive products that are unsuitable”.

The review was triggered by the fact that interest-only (IO) loans are now often more expensive than principal & interest loans, and it is therefore becoming “ever important now for lenders and brokers to explain and justify why they are putting people into more expensive loans”.

Speaking to The Adviser, Michael Saadat, ASIC’s senior executive leader for deposit takers, insurers & credit services, elaborated that while the regulator believes that brokers are having the appropriate discussions with consumers about the reasons for taking out IO loans, the record keeping on loan files has not been of a high standard.

He revealed: “In the past, I’d say we have seen pretty poor record keeping on that front, where there has been very little on the loan file which tells you why the consumer got that product. In general, when we have looked at loan files in the past, we have seen [responses to the question]: ‘What were the consumers’ requirements and objectives?’ In many cases, we see things like: ‘To buy a house’. That is pretty implicit, but it really doesn’t tell you too many things about what type of product, what type of loan, what type of rate, etc.

“So, our view is that although these discussions are happening… brokers are having these discussions, but they’re not recording the outcomes of those discussions. And it’s hard to prove that you’re meeting your obligations if you don’t have something on a file that shows why you have recommended a particular loan.”

What ASIC wants to see on IO loan files

Mr Saadat added that the next stage of the review into interest-only loans will be “getting these individual files and looking to see how consumers’ requirements and objectives have been documented on those files”.

He said: “If [borrowers] have been provided with an interest-only loan and they are an owner-occupier, we will be looking for a summary or an explanation on the loan file that describes why the consumer was provided with an interest-only loan. So, that’s really the key thing.”

Adding that ASIC “won’t be that prescriptive in terms of our expectations”, Mr Saadat revealed that what the regulator wants to see is “information on the file which is sufficient to explain why the consumer’s decision (or suggestion from the lender or broker) to go into an interest-only for an owner-occupier loan was the right one”.

The lending industry has already begun responding to some of these concerns, with Commonwealth Bank launching a new IO simulator to help brokers show customers the differences between these type of repayments as well as principal & interest repayments.

Mr Saadat told The Adviser that these types of tools, which delve deeper into why consumers need an IO product, help “make the consumer aware of some of the risks involved with going down a particular path”; for example, “the fact that at the end of that period, you do need to make higher principal and interest payments and, over the life of the loan, you may end up paying more interest as a result”.

Mr Saadat concluded: “Investors may have other reasons for getting an interest-only loan — they may be tax reasons, for example, whereas those reasons don’t necessarily apply to owner-occupiers. And that doesn’t mean that owner-occupiers should never have been given an interest-only loan. Of course, there will be cases where that still is appropriate. We just want to make sure that it is appropriate and that you’re documenting the reasons for that.”

The regulator’s crackdown on IO loans has begun to bite, according to some industry data. New data from Mortgage Choice has revealed that there was a 60 per cent decline in interest-only mortgages over a period of just six months.

According to Mortgage Choice’s latest home loan approval data, the proportion of interest-only loans written by the brokerage dropped from 35.95 per cent in April 2017 to 14.64 per cent in September 2017.

CEO of Mortgage Choice John Flavell said that the “significant decline” was a result of lenders hiking rates for these loans.

Australian investors may be heading towards the ‘cliff edge’ on loan repayments

From Business Insider.

Recent restrictions on interest-only lending have increased concerns around Australian housing stability, if investors are forced to start paying down principal in addition to the interest on their loan.

In a note titled “Cliff edge”, housing expert Pete Wargent said those stricter lending standards have led to speculation an increasing number of borrowers could topple over a “principal and interest cliff” when their interest-only loan expires and they’re unable to roll it over.

Most interest-only loans have a five-year term, at which point it’s rolled over or converts to principal & interest repayments.

“The repayments might be up to 40% or more higher when the principal payments kick in, so household cashflows need to be carefully managed,” Wargent said.

Interest-only lending peaked in 2015 before APRA’s first round of macro-prudential restrictions. In view of that, Wargent expects the highest number of interest-only loan terms will be due to roll over in 2020.

This chart shows Wargent’s estimate of the dollar value of interest-only loans for which borrowers will be forced to convert to principal & interest repayments:

Source: Pete Wargent Daily Blog

As part of macro-prudential measures introduced in March to try and curb property market speculation, APRA put a cap on interest-only lending at 30% of all new loans.

Australian banks also offered no-cost switches into principal & interest repayment plans, and enforced stricter loan to value (LVR) requirements for interest-only borrowers.

Based on those changes, “it’s possible to make a rough assessment or estimate of the value of IO loans falling due approved under conditions that would likely fail today’s underwriting standards”, Wargent said.

The estimates suggest that around $40-55 billion in interest-only loans will come up for renewal between 2018 and 2020.

“By 2016, the share of new interest-only loans in the market had been pared back, and therefore the P&I cliff will also begin to taper off by 2021,” he added.

This chart from Citi provides a good measures of how rampant interest-only lending was in 2015, to borrowers now facing revised loan-terms in 2020.

In the March quarter of 2015, interest-only lending made up almost half of new loan flow:

In a research report released this morning, Citi also calculated that the total value of interest-only loans in Australia currently amounts to approximately $643 billion.

The bulk of interest-only loans are taken up by investment professional for tax benefits. However, Citi also reported a sharp rise in interest only loans taken out between 2011 and 2017 by the “suburban mainstream” — middle income workers and younger families.

Based on those figures, if income growth remains low a number of Australian households could be facing increased pressure from a sharp rise in mortgage costs over the next three years as interest-only loan terms expire.

Wargent expects the changes to suck some “hot air” out of Australia’s property market. “I don’t know if it’s a doomsday scenario, but it will most likely make property less attractive as an asset class”, he told Business Insider.

“In the wash-up, one can’t help but feel that investors that opted for quantity over quality of investment properties might be left staring down the barrel of some unenviable decisions.”

More Evidence Of The Risks Of Interest Only Loans

Citi has published a 54 page report on the highly topical subject of interest only (IO) loans, and we provided data from our Core Market Model to assist their research.

Even after recent regulatory tightening, they highlight that underwriting standards in Australia are still more generous than some other countries.

They conclude that there are vulnerabilities in the IO sector, both from property investors and owner occupied IO loan holders.

They say that tighter lending criteria and rising house prices has meant investors increasingly face net negative cash flows and investors face a growing household cashflow gap and reducing capital gains expectations.

The large levels of debt outstanding by borrowers aged in their 50’s and 60’s means many investors will need to sell property to discharge their debts.

Owner Occupied IO borrowers are more susceptible to interest rate rises given higher average borrowing levels and higher average loan to
value ratios. Our mapping of OO IO borrowers between 2011 and 2017 highlights the spread of these loans.

They conclude that:

all major lenders face a responsible lending risk – Westpac and CBA have more customers who will need to adjust to the new realities of investing in the residential property market in Australia. Given the widespread use of IO finance and the reduced prospects of discharging debt via means other than liquidation of portfolio holdings, banks must face an increased risk of mis-selling claims in future years. Mining towns serve as a microcosm of this threat.

The spooky mortgage risk signs our bankers are ignoring

From The Conversation.

I’m not normally a fan of parliament hauling private sector executives before them and asking thorny questions. But when the Australian House of Representatives did so this week with the big banks it was both useful and instructive.

And, to be perfectly frank, terrifying.

Let’s start with Westpac CEO Brian Hartzer. First, he confirmed the little-known but startling fact that half of his A$400 billion home loan book consists of interest-only mortgages.

Yep, half. Of A$400 billion. At one bank. Oh, and ANZ, CBA and NAB are all nearly at 40% interest-only.

Hartzer went on to make the banal statement: “we don’t lend to people who can’t pay it back. It doesn’t make sense for us to do so.”

So did it make sense for all those American mortgage lenders to lend to people on adjustable rates, teaser rates, low-doc loans, no-doc loans etc. before the global financial crisis?

Of course not. The point is that banks are not some benevolent, unitary actor taking care of their own money. There are top managers like Harzter acting on behalf of shareholders. Those top managers delegate authority to lower-level managers, who are given incentives to write lots of mortgages. And, as we know, the incentives of those who make the loans are not necessarily aligned with those of the shareholders. Those folks may well want to make loans to people who can’t pay them back as long as they get a big payday in the short term.

ANZ CEO Shayne Elliot repeated Hartzer’s mantra, saying: “It’s not in our interest to lend money to people who can’t afford to repay.” Recall, this is the man who on ABC’s Four Corners said that home loans weren’t risky because they were all uncorrelated risks (the chances that one loan defaults does not affect the chances of others defaulting). That is a comment that is either staggeringly stupid or completely disingenuous.

Messers Harzter and Elliot must take us all for suckers. They have made a huge amount of interest-only loans, at historically low interest rates, to buyers in a frothy housing market, who spend a large chunk of their income on interest payments. This certainly looks troubling. It may not be US sub-prime, but it could be ugly. Very ugly.

To put it in context, there appears to be in the neighbourhood of A$1 trillion of interest-only loans on the books of Australian banks. I say “appears to be” because reporting requirements are so lax it’s hard to know for sure, except when CEOs cough up the ball, like this week.

The big lesson of the US mortgage meltdown is that the risks on these mortgages are all correlated. If a few people aren’t paying back an interest-only loan, that is a fair predictor that others won’t pay back their loans either. Yet it seems Australian banks are a decade behind the learning curve.

The Reserve Bank cautions that one-third of borrowers don’t have a month’s repayment buffer. And where are interest rates going to go from here? Up. It is just a question of when. And when that does happen – or when the interest-only period on loans (typically five years) rolls off and principal payments start having to be made – watch out.

We should all remember that the proximate cause of the US mortgage meltdown was borrowers with five-year adjustable-rate mortgages (ARMs) that had huge step-ups in repayments and needed to be refinanced to be serviceable. When the market couldn’t bear that refinancing, defaults went up. Then the collapse of US investment bank Bear Stearns, then Lehman, then Armageddon.

Australia’s large proportion of five-year interest-only loans – turbocharged by an out-of-control negative-gearing regime – looks spookily similar.

It’s one thing for borrowers to do silly things. When it becomes dangerous is when lenders not only facilitate that stupidity, but encourage it. That seems to be what has happened in Australia.

And APRA’s “crackdown” and the Reserve Bank’s warning may be far too little, way too late.

We might stumble though this. I hope we do. But if so, it will be because of dumb luck, not good institutional and regulatory design. And definitely not because of good corporate governance.

Whatever happens, we should learn those lessons.

Author: Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW

ASIC update on interest-only home loans

ASIC today provided an update on its targeted review of interest only home loans. They say that borrowers who used brokers were more likely to obtain an interest-only loan compared to those who went directly to a lender and borrowers approaching retirement age continue to be provided with a significant number of interest-only owner-occupier loans.

ASIC will now look at individual loan files, especially from lenders with high IO portfolios, in the light of the responsible lending provisions.

Announced in April 2017, the review was a targeted industry surveillance examining whether lenders and mortgage brokers are inappropriately recommending more expensive interest-only loans.

With many lenders, including major lenders, charging higher interest rates for interest-only loans compared with principal-and-interest loans, lenders and brokers must ensure that consumers are not provided with unsuitable interest-only home loans.

ASIC has concluded the first stage of its targeted review, which involved data collection from 16 home loan providers (including large banks, mid-tier and smaller banks, and non-bank lenders).

ASIC found that Australia’s major banks have cut back their interest-only lending by $4.5 billion over the past year. However, other lenders have partially offset this decline by increasing their share of interest-only lending.

The 16 lenders reviewed by ASIC provided $14.3 billion in interest-only loans to owner-occupiers in the June 2017 quarter, down from $19 billion in the September 2015 quarter.

ASIC’s interest-only lending review has also found:

Borrowers who used brokers were more likely to obtain an interest-only loan compared to those who went directly to a lender

Borrowers approaching retirement age continue to be provided with a significant number of interest-only owner-occupier loans

ASIC has now moved into the second stage of its review, and will be reviewing individual loan files from both lenders and mortgage brokers. These lenders and mortgage brokers have been selected based on a number of criteria, including their relative share of interest-only home lending.

ASIC will examine individual loan files to ensure that lenders are providing interest-only home loans in appropriate circumstances. ASIC will carefully review cases where owner-occupiers have been provided with more expensive interest-only home loans, to ensure that consumers are not paying for more expensive products that are unsuitable.

Under the responsible lending obligations, lenders and brokers are required to make sure that a loan meets the requirements and objectives of a consumer, in addition to making sure that the loan is affordable. Lenders and brokers must have a reasonable basis for suggesting that a consumer apply for a particular loan product, and no consumer should be surprised by the type of home loan product that they have obtained.

In providing the update, ASIC Deputy Chair Peter Kell said he expected lenders offering these types of loans to be making thorough enquiries into the financial status and the needs of their clients:

“The spotlight has been firmly on interest-only lending for some time, and there are no excuses for lenders and brokers not meeting their legal obligations,” he said.

“While interest-only loans may be a reasonable option for some borrowers, lenders must make appropriate enquiries into the needs and financial circumstances of their customers, and they must be able to demonstrate that they have done so.”

ASIC will consider appropriate enforcement action if breaches of the law are identified.

Background

ASIC collected data from the following lenders covering their interest-only lending activities over the last two years:

Australia and New Zealand Banking Group Limited

Australian Central Credit Union Ltd (trading as People’s Choice Credit Union)

Bank of Queensland Limited

Bendigo and Adelaide Bank Limited

Citigroup Pty Limited

Commonwealth Bank of Australia

ING Bank (Australia) Limited

La Trobe Financial Services Pty Limited

Liberty Financial Pty Ltd

Macquarie Bank Limited

Members Equity Bank Limited

National Australia Bank Limited

Pepper Group Limited

Suncorp-Metway Limited

Teachers Mutual Bank Limited

Westpac Banking Corporation

ASIC has provided guidance to industry in Regulatory Guide 209 Credit licensing: Responsible lending conduct (refer: RG 209).

In 2015, ASIC reviewed interest-only loans provided by 11 lenders and issued REP 445 Review of interest-only home loans (refer: REP 445), which made a number of recommendations for lenders to comply with their responsible lending obligations (refer: 15-297MR).

In 2016, ASIC reviewed the practices of 11 large mortgage brokers and released REP 493 Review of interest-only home loans: Mortgage brokers’ inquiries into consumers’ requirements and objectives (refer: REP 493). REP 493 identified good practices as well as opportunities to improve brokers’ practices.

Responsible lending is a key priority for ASIC in its regulation of the consumer credit industry. ASIC’s targeted surveillance of interest-only lending follows considerable regulatory activity focused on responsible lending compliance:

Treasury releases ASIC’s Review of Mortgage Broker Remuneration.

ASIC announces further measures to promote responsible lending in the home loan sector (refer: 17-095MR).

ASIC filed civil penalty proceedings against Westpac in the Federal Court on 1 March 2017 for alleged breaches of the National Consumer Credit Protection Act 2009 (refer: 17-048MR).

Borrowers with concerns about their ability to make home loan repayments should contact their lender in the first instance. ASIC’s MoneySmart website has guidance for consumers who are having problems paying their mortgage, including how to approach their lender. They can also access free external dispute resolution, through either the Financial Ombudsman Service or Credit and Investments Ombudsman.

Are IO Households Aware They Have IO Loans?

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.

Suncorp Lifts Interest Only Loan Rates

From Australian Broker.

Suncorp has today announced it is introducing new pricing methodology for interest only home lending.

Banking & wealth CEO David Carter said the bank currently calculated interest only rates based on the purpose of the loan, but would now also take into account the type of loan repayment.

“Currently, our interest only home lending is priced at the same rate as principal and interest home lending, however following recent changes in the market we have made changes to our systems to differentiate between borrowers repaying interest only, and those repaying principal and interest,” Carter said.

“This change is important as it will ensure the bank can maintain its position relative to regulatory requirements.

“With the market having effectively repriced interest only lending, and with some lenders having opted out of certain aspects of the market, it’s important for us to also support the focus on this type of lending.

“We are writing to customers this week to advise them of this change and the new interest only rates, which will come into effect on 1 November, 2017.

“As recently announced, we have launched a number of special offers, as well as reductions to some of our fixed rates, giving customers greater choice if they are wanting to move to a principal and interest product, and customers asking to switch will not be charged a fee for doing so.”

Suncorp says it recognises that increases in interest rates have an impact on customers with rate increases that remain below most other lenders. Variable interest rates on existing owner-occupier interest only rates will increase by 0.10% p.a and variable interest rates on all investor interest only rates will increase 0.38% p.a., effective 1 November, 2017.

Despite the changes, Suncorp says that its rates remain highly competitive with the majority of customers continuing to pay rates well below the headline, due to the various features and benefits of the bank’s products.

Variable interest rates on existing principal and interest owner-occupier and investor rates remain unchanged. Pricing for interest only construction loans also remain unchanged.

CBA introduces new IO ‘simulator’

From Australian Broker.

The Commonwealth Bank of Australia (CBA) has announced a compulsory new digital tool, the Interest Only Simulator, which will be incorporated into its third party lending process.

The simulator will be accessible through CommBroker and will show customers the differences between IO and P&I repayments as well as the financial impacts over the life of the loan for both types of loans. It will be mandatory from 6 October for all customers applying for a new interest only loan.

“The new tool will make it easier for our brokers to have conversations with customers about their needs and their loan options. It will also help ensure customers understand what type of loan is best for them and their situation,” a CBA spokesperson told Australian Broker.

A compulsory Customer Acknowledgement Form will also be included in the simulator. This will be submitted with all interest only home loan applications to ensure that those payments meet the client’s needs.

Brokers are required to provide customers with a copy of this form as a record of the discussion. This can be done electronically as a pdf attachment via email.

“We encourage our customers to choose principal and interest repayments to help them build equity in their home, where this meets their needs and objectives. Customers who currently make interest only payments are encouraged, where they are able, to switch to principal and interest repayments,” the spokesperson said.

CBA doubles waiting period for IO switch

CBA has doubled the waiting period for customers seeking to switch to an interest-only repayment loan from 90 days to 180 days. This is a further move to try to reduce the proportion of IO loans held, following regulatory pressure to meet the 30% limit. CBA has already lifted interest rates, tightened lending criteria and throttled back applications via mortgage brokers.

From The Adviser. As of 31 July, customers with Commonwealth Bank (CBA) will be required to wait 180 days to change to an interest-only (IO) loan, while requests to switch within 180 days of loan funding will be sent on for credit assessment.

In addition, clients with loan-to-value ratios (LVR) of more than 80 per cent will not be able to refinance from a principal and interest (P&I) loan to IO within 180 days of funding.

Effective on the same date, the maximum IO terms have been reduced (over the life of the loan) to five years for owner-occupied home loans and 10 years for investment home loans.

Document identification

CBA is also changing the application identification process for new clients, effective 31 July. Brokers will need to acknowledge that they have viewed original identification documents for all borrowers and guarantors, and brokers must provide clear copies of the original (and sighted) identification documents when the application is submitted.

Furthermore, in the case of multiple applicants, brokers must submit each applicant’s identification documents on separate pages for each loan application.

CBA warned: “Missing documentation or discrepancies may result in delays to the customers’ application.”