Interest Only Loans – Page 6 – Digital Finance Analytics (DFA) Blog

One In Three Households Have No Mortgage Buffer – RBA

The latest Financial Stability Review from the RBA has a different tone to it, compared with previous edition, because whereas they have previously played up the “cushion” some households have by paying their mortgages ahead, now they say one third of households have no buffer and are exposed to potential interest rate rises. What has changed is not the underlying data, but how it is being presented. Here are some key extracts.

In Australia, vulnerabilities related to household debt and the housing market more generally have increased, though the nature of the risks differs across the country. Household indebtedness has continued to rise and some riskier types of borrowing, such as interest-only lending, remain prevalent. Investor activity and housing price growth have picked up strongly in Sydney and Melbourne. A large pipeline of new supply is weighing on apartment prices and rents in Brisbane, while housing market conditions remain weak in Perth.

Nonetheless, indicators of household financial stress currently remain contained and low interest rates are supporting households’ ability to service their debt and build repayment buffers.

The Council of Financial Regulators (CFR) has been monitoring and evaluating the risks to household balance sheets, focusing in particular on interest-only and high loan-to‑valuation lending, investor credit growth and lending standards. In an environment of heightened risks, the Australian Prudential Regulation Authority (APRA) has recently taken additional supervisory measures to reinforce sound residential mortgage lending practices. The Australian Securities and Investments Commission has also announced further steps to ensure that interest-only loans are appropriate for borrowers’ circumstances and that remediation can be provided to borrowers who suffer financial distress as a consequence of past poor lending practices. The CFR will continue to monitor developments carefully and consider further measures if necessary.

Investor credit has also risen noticeably over the past six months, with investor demand particularly strong in Sydney and Melbourne (Graph 2.3).

Overall household indebtedness has increased while income growth has remained weak. Some types of higher-risk mortgage lending, such as IO loans, also remain prevalent and have increased of late.

The risks associated with strong investor credit growth and increased household indebtedness are primarily macroeconomic in nature rather than direct risks to the stability of financial institutions. Indeed, some evidence suggests that investor housing debt has historically performed better than owner-occupier housing debt in Australia, though this has not been tested in a severe downturn. Rather, the concern is that investors are likely to contribute to the amplification of the cycles in borrowing and housing prices, generating additional risks to the future health of the economy. Periods of rapidly rising prices can create the expectation of further price rises, drawing more households into the market, increasing the willingness to pay more for a given property, and leading to an overall increase in household indebtedness. While it is not possible to know what level of overall household indebtedness is sustainable, a highly indebted household sector is likely to be more sensitive to declines in income and wealth and may respond by reducing consumption sharply.

A further risk during periods of strong price growth is that it may be accompanied by an increase in construction that could result in a future overhang of supply for some types of properties or in some locations. In this environment, as well as amplifying the upswing for such properties, any subsequent downswing is likely to be larger and more likely to see prices and rents fall if the vacancy rate rises. This poses risks to the whole housing market and household sector, not just to the recent investors.

While the financial position of households has been fairly resilient, vulnerabilities persist for some highly indebted households, especially those located in the resource-rich states. Household indebtedness (as measured by the ratio of debt to disposable income) has increased further, primarily due to rising levels of housing debt, although weak income growth is also contributing. Rising indebtedness can make households more vulnerable to potential income declines and higher interest rates. This is of most concern for households that have very high levels of debt.

Low interest rates are helping to offset the cost of servicing larger amounts of debt and hence total mortgage servicing costs remain around their recent lows (Graph 2.5). In this regard, lenders have tightened mortgage serviceability assessments in recent years to include larger interest rate buffers, which should provide some protection against the potential effects of higher interest rates.

Prepayments on mortgages increase the resilience of household balance sheets. Aggregate mortgage buffers – balances in offset accounts and redraw facilities – are high, at around 17 per cent of outstanding loan balances or around 2½ years of scheduled repayments at current interest rates. However, these aggregate figures mask significant variation across borrowers, with available data suggesting that around one-third of borrowers have either no accrued buffer or a buffer of less than one month’s repayments. Those with minimal buffers tend to have newer mortgages, or to be lower-income or lower-wealth households.

Interest-only (IO) loans account for a sizeable and growing share of total housing credit in Australia, now representing around 23 per cent of owner‑occupier lending and 64 per cent of investor lending (Graph B1). IO lending has the potential to increase households’ vulnerability in part due to the higher average level of indebtedness over the life of an IO loan compared with a regular principal-and-interest (P&I) loan.

For some time regulators have highlighted the potential risks associated with IO compared with P&I loans. Because IO loans allow borrowers to remain more indebted for longer, there may be greater credit risks associated with such loans. When loan balances stay high, there is an increased risk of borrowers falling into negative equity should housing prices decline.

Another risk is that borrowers may find it difficult to service higher required payments at the end of the IO period, which increases the chance of default. For example, repayments on a $400 000 loan with a 4 per cent interest rate and a five-year IO period would typically increase by around 60 per cent at the end of the IO period. While some borrowers may have planned to refinance into another IO loan at the end of the IO period, this may be difficult if circumstances have changed.

Borrowers who anticipate future price rises can use IO loans to maintain a higher level of leverage for a given servicing payment, thereby magnifying their returns from rising housing prices but also magnifying any losses. More generally, at an aggregate level this behaviour could induce a more pronounced cycle in housing prices than would otherwise occur, amplifying the size of any subsequent downswing in housing prices.

Why regulators are so spooked by interest-only loans

From The NewDaily.

Australia’s financial regulators fear the ticking time bomb of interest-only loans will explode if rates rise or house prices crash, according to keen observers of the latest crackdown.

Corporate watchdog ASIC and financial regulator APRA have landed a one-two punch on interest-only lenders in recent days, with the “full support” of the Reserve Bank.

Professor Tony Dalton, an expert at the Australian Housing and Urban Research Institute, said regulators are worried that rate rises will cripple families who have been tempted by the lure of ‘interest-only’ to borrow beyond their means.

“The big one they’re worried about is interest rate rises pushing households into trouble. That’s the big worry,” he told The New Daily. “If interest rates were to increase late this year or into next, many households will have very little money left.”

Interest-only loans are short-term gain for long-term pain. They allow borrowers to pay below-average repayments for between five and 15 years before they are slugged double for the remainder.

During the honeymoon period borrowers pay, in the colourful language of Reserve Bank Governor Philip Lowe, “not even one dollar of principal”. In a speech on Tuesday night he called this practice “unusual by international standards” and warned Australians to beware.

“A reduced reliance on interest-only loans in Australia would be a positive development and would help improve our resilience. With interest rates so low, now is a good time for us to move in this direction,” Dr Lowe said.

“Hopefully, the changes might encourage a few more people to think about the merit of taking out very large interest-only loans when interest rates are near historical lows.”

The loans are most popular with investors (as they claim interest expenses as tax deductions), but ASIC has warned that lenders are also selling them to owner occupiers in “unsuitable” circumstances.

Finance analyst Martin North said the loans are effectively a dangerous gamble on the proposition that prices will rise.

“In a rising market they’re absolutely fine, tickety-boo. But if you’re buying now with an interest-only loan at the top of the market, there’s a 50-50 chance at least that prices drop rather than rise,” Mr North told The New Daily.

In an ideal world, a family would save like crazy during the honeymoon years, then pay down the principal in a lump sum or refinance to access the equity they’ve accrued.

For example, a family with a $600,000 loan at a variable rate of 4 per cent repays $2000 a month in the seven-year interest-only period, then $3300 for the remaining 23 years, presuming no rate rises.

At the end of the seven years, the house is worth $750,000 and the family has saved $500 a month at 2.5 per cent interest, leaving them with a lump sum of just over $45,000.

They refinance to access the extra $150,000 in equity and use savings to pay down the principal. The bet paid off.

But what if they saved nothing? Or rates rose? Or house prices collapsed?

Imagine instead the family is tempted to buy a more extravagant $750,000 home. They can’t really afford it, but with an interest-only loan they only have to pay $2500 a month for seven years, before repayments spike to $4200.

However, there’s been a market correction. The house is still only worth $600,000, and one parent is out of work. They’ve saved nothing – and racked up $3000 on the credit card.

They can’t refinance as there’s no equity to borrow against. Their rainy day fund is depleted. And then the Reserve Bank hikes the cash rate, pushing their variable rate to 4.5 per cent and their monthly repayments to $4400.

As Mr North put it: “You are stuck with a loan you cannot repay.”

And the trigger wouldn’t need to be the RBA. Commercial banks have already announced out-of-cycle rate hikes for interest-only loans in December and March.

Interest-only loans are now up to 22 basis points higher than the alternative, according to comparison firm Mozo.

The Interest-Only Loan Debt Trap II

Last October we wrote a series of posts on the risks related to interest only loans. Given recent developments, and the belated focus from APRA and ASIC, we revisit the topic today.

Here is a plot from the APRA data showing the relative movement of investor loans and interest only loans. Yes, there is a correlation! The ABC’s Phil Lasker used this chart in the TV News on Friday.

Lenders will 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

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 what is happening at the coal face? To find out we included some specific questions in our household survey, and today we present the results.

We were surprised to find that around 83% of existing interest-only loan holders expect to roll their loan to another interest-only loan, and to keep doing so. More concerning, only around 44% of borrowing households had an explicit discussion with the lender (or broker) at their last loan draw down or reset about how they plan to repay the capital amount outstanding. Some of these loans are a few years old.

Around 57% said they knew the capital would have to be repaid (we assume the rest were just expecting to roll the loan again) and 26% had no firm plans as to how to repay whereas 39% had an explicit plan to repay.

Many were expecting to close the loan out from the sale of the property (thanks to capital appreciation) at some point, from the sale of another property, or from another source, including an inheritance.

Thus we conclude there is a potential trap waiting for those with interest-only loans. They need a clear plan to repay, at some point. It also highlights that the quality of the conversation between borrower and lender is not up to scratch.

We think some borrowers on an interest-only loan may get a rude shock, when next they try to roll their interest-only loan. If they do not have a clear repayment plan, they may not get a new loan. There is a debt trap laid for the unwary and the APRA guidelines have made this more likely.

Back in 2014, we wrote about the interest only situation in the UK.

So, now lets look at the UK experience. There are 11.3 million mortgages in the UK, with loans worth over £1.2 trillion. At the end of 2013 there were an estimated 2.2 million pure interest-only loans outstanding, and a further 620,000 part interest-only, part repayment mortgages outstanding on lenders’ books. Compared to 2012 this represents a fall of around 300,000 pure interest-only mortgages (down 12%), and around 90,000 part-and-part mortgages (down 13%).

According to the Council for Mortgage Lenders, at the peak of their popularity in the late 1980s, interest-only mortgages accounted for more than 80% of all loans taken out. This year, however, lenders are likely to advance only around 40,000 new interest-only loans for residential house purchase, less than 10% of the total.

Among first-time buyers, the decline in interest-only borrowing has been particularly pronounced. CML data shows that only 2% are taking out interest-only mortgages, with 98% opting for repayment loans. Interest-only accounts for a higher proportion of new borrowing by existing owner-occupiers who are moving (10%) and those remortgaging (13%).

Most new interest-only borrowing is in the buy-to-let market (aka investment mortgage), where this option remains the norm for very good reasons. Fixed-rate interest-only mortgages minimise costs for landlords and are more likely to produce a profitable margin. Interest-only mortgages also enable landlords to meet lenders’ requirements that their rental income produces an average minimum cover of 125% of their borrowing costs.

A couple of years back, there were concerns in the UK that interest only loans may be a problem, and alongside regulatory commentary, CML produced an “interest-only toolkit” designed to help mortgage lenders to work with their interest only mortgage customers, especially those loans due for repayment before 2020.

The regulators reached the conclusion that 90% of interest-only mortgage holders have a repayment strategy in place. Lenders made a commitment with the regulator (the Financial Conduct Authority) to contact interest-only loan holders and ask about their repayment plans. The CML via it lender members found that Lenders have been using a variety of contact strategies. In addition to reminders and mailings requesting the customer’s written response (including questionnaire responses), telephone calls, face-to-face meetings and even home visits are also used by some lenders. Overall, around 30% of customers contacted have so far responded.

Among those borrowers who have responded, around four out of five already had a clear plan. Among those who did not, the survey found that the solutions and approaches lenders are offering typically include term extensions, permanent conversions to capital and interest, and overpayments.

There has also been a positive set of changes in the loan-to-value profile of outstanding interest-only mortgages. Two-thirds of outstanding interest-only mortgages have loan-to-value (LTV) ratios of less than 75% – and the vast majority of these are not due to mature until after 2020.

The chart shows that a large number of loans would have moved into a lower LTV band as a result of house price inflation alone. However, it also shows that borrowers are taking additional action to reduce their mortgage balances, as the effect of house price inflation alone would not have resulted in the improvements in outstanding LTVs that have been seen over the past year. Indeed, the number of loans in every LTV band below 75% would have seen an increase on the basis of house price inflation alone (as loans moved down from higher LTV bands) – but, in fact, every band saw a decrease.

Changes in interest-only loans outstanding, September 2012-December 2013, by LTV

Under the new mortgage regulations now in force in the UK, lenders may offer interest only loans, but only if a borrower has a credible repayment plan, at the time of application.

So some points to ponder.

1. How many interest only loans in Australia have a credible repayment strategy? To what extent is this considered by borrowers and lenders at the time of application?

2. Will rising house prices be the solution to interest-only loan repayment?

3. Are the review processes (on average each 5 years in Australia, even if the loan term is 25/30 years) sufficiently robust to identify potential issues?

4. Does Negative Gearing lead to a greater dependence on interest-only loans?

CBA Lifts Investor Interest Only Mortgage Rates

Today the CBA has announced changes to some mortgage rates: interest only home loan rates for investors will rise by 12 basis points and Viridian Line of Credit (VLOC) products will increase by 4 basis points. The new interest only standard variable rate for investors will be 5.68% per annum, VLOC will move to 5.82% per annum.

These changes will be effective from 3 April. For customers who may want to switch to principal and interest repayments to avoid this increase, they can do so easily – online, over the phone or in branch – at no cost.

CBA supported 140,000 new home loans in the six months ended December 2016 and our standard variable rate (SVR) for owner occupiers of 5.22% per annum remains the lowest among the major banks.

They just released their 1H17 results, which show a statutory net profit after tax (NPAT) of $4,895 million, which represents a 6 per cent increase on 1H16 period. Cash NPAT was $4,907 million, an increase of 2 per cent on the prior comparative period. Return on equity (cash basis) was 16 per cent.

Strikingly though the net interest margin was down 4 basis points to 2.11%, or 2.08% excluding treasury, down 5 basis points.

We will provide more detailed commentary later.

Caution as interest-only mortgages continue to rise

From News.com.au.

Has Australia gotten too swept up in our great love affair with property?

And they have been consistently rising for close to a decade, since the Australian Prudential Regulation Authority (APRA) started releasing this data in 2008.

According to APRA’s latest quarterly property exposure statistics, released last week, interest-only home loans increased by almost $8 billion in the September 2016 quarter. These types of mortgages now make up 39 per cent of all residential home loans.

But with evidence that house price growth is easing — capital gains recorded over November were the softest they have been since December 2015 — and with mortgage rates on the way back up, the rise in interest-only lending is beginning to ring alarm bells.

“In slow growth markets, which most markets in Australia currently are, if you’re not paying down the principal loan amount and there is a market event that leads to a drop in property prices, a homeowner with an interest-only loan could be left dangerously exposed,” the CEO of HomeStart Finance, John Oliver said.

“Even in current high-growth markets such as Melbourne and Sydney, there is speculation about a potential bursting of the property bubble. If this happens, it could lead to a lot of homeowners losing their properties.

“Australia’s property market is littered with periods when the value of properties actually fell, such as the Sydney market between 2004 — 2007 where prices fell by 8 per cent and Adelaide between 2010 — 2013 where prices fell by 4 per cent.”

CoreLogic figures showed Melbourne house prices dropped by 1.5 per cent in November while Sydney prices rose by just 0.8 per cent. The combined capital city index grew by just 0.2 per cent over the month.

A SLEEPING PROBLEM

Interest-only home loans have typically been popular among property investors because it minimises mortgage repayments in the short-term while investors bank on capital growth in the long-term. So with property investors such a strong force in the Australian property market, Martin North, Principal of Digital Finance Analytics said the increasing popularity of interest-only isn’t surprising.

“We need to understand who are getting those interest-only loans. There is a very strong correlation between interest-only loans and greater investment lending,” Mr North told news.com.au.

“In the last three or four months we have seen investors come back and investor loans are driving the market again.”

But this love affair with property investment, and the subsequent rise in interest-only lending, could now start to cause real headaches at a time when interest rates are starting to rise.

“We have got two issues. The first issue is we have got this continued growth with investor loans and my research tells me investors are still pretty keen on the market … and therefore interest-only loans are being sold,” Mr North said.

“The second issue is we have got interest-only loans with people currently and when they come up for renewal, with interest rates rising, the bank will be asking harder questions about whether they can refinance and repay the capital. And some of those [investors], from my surveys, would indicate they don’t have a plan to repay the capital. That means there is a sleeping problem for those with interest-only loans currently.”

Research from Digital Finance Analytics shows more than eight in ten existing interest-only loan holders expect to refinance their loan to another interest-only loan and more than a quarter had no firm plans as to how they were going to repay if they couldn’t enter another interest-only agreement. Banks, who don’t want borrowers on interest-only terms for long periods, offer fixed-terms on interest-only mortgages, with the average term lasting five years.

This leaves us with a significant amount of investors who have taken advantage of interest-only mortgages, and are “ill-prepared” to switch to principal-and-interest.

They have assumed that price growth will continue at stratospherical levels so they will be able to sell their property and repay the loan, said Mr North, or they have assumed they will be able to continue to roll their loan over on interest-only terms. But house price growth is cooling and banks are tightening interest rates and loan approvals.

“It creates a series of small earthquakes. Those might be tremors that don’t go anywhere but if you think about it in the context of interest rates rising, house price growth slowing going forward, and people who own investment properties who are already underwater in terms of rental yields, and they now find they can’t actually refinance the loan under interest-only terms …

What I’m feeling is people are going to have a nasty shock,” Mr North said.

“If [investors] do run to the exit, they still have got to repay the loan they have got on the property … But if you have a situation where there is a significant downturn, and property prices drop dramatically, then you could be in a situation where some of the interest-only borrowers won’t be able to repay their loans and that could be a significant downward force on the market.”

A WIDER PROBLEM

APRA’s data shows the concern extends beyond property investors. While interest-only home loans are mostly used by investors, owner-occupiers are resorting to this type of structure too, at higher levels than ever.

At the end of the September 2016 quarter, the value of interest-only loans exceeded the value of investment loans by almost $60 billion, compared to just $18 billion a year earlier. At the end of the September 2014 quarter, two years ago, the value of interest-only mortgages was $26 billion less than the value of mortgages to investors. That’s a turnaround of $86 billion in two years.

“At a time when living costs continue to rise there’s no doubt that home buyers, and in particular first-time buyers, see interest-only loans as a quick fix to get into their own home sooner, while also managing everyday costs,” Mr Oliver said.

A sobering thought given a fifth of young borrowers already can’t make their mortgage repayments when rates are at record lows.

So if the market does drop and rates rise, it is not just investors who are headed for trouble.

“If they are not paying any money off the home, no headway is being made on the overall mortgage. By paying off the interest for up to 10 years, no equity will be built up in the home if property prices aren’t rising,” Mr Oliver said.

“If housing prices drop or there is a downturn in the economy then they could be forced to sell the property at a loss, or the banks may repossess the property.”

Westpac Ups Interest Only Rates

Alongside NAB’s rate hike, Westpac also announced a lift in their interest only mortgage rates for investors. They also highlight switching to a principal and interest repayment loan offers a lower rate.

Effective 16 December 2016, Westpac will increase the interest rates of some of its Interest Only variable home lending products, including:

Variable home loan (owner occupier) rate for customers with Interest Only repayments: by 0.08% to 5.41% per annum (comparison rate 5.55% per annum*);

Variable residential investment property loan rate for customers with Interest Only repayments: by 0.08% to 5.68% per annum (comparison rate 5.82% per annum*).

Equity Access loan rate: by 0.15% to 5.80% per annum.

Our interest rates are constantly under review, as market and economic conditions change.

Switching from Interest Only to principal and interest repayments

We offer lower interest rates to customers who make principal and interest repayments to encourage them to pay down their debt and own their home faster.

If you wish to pay your home loan sooner by switching to principal and interest repayments, you can do so by contacting us on 132 558 and we’ll talk through your options.

Customers with Premier Advantage Package can switch at any point in time at no additional cost.

Impact on my repayments?

For Interest Only home loans, your repayments are adjusted automatically. The repayments will change from the first repayment date after the interest rate change becomes effective.

Lenders Are Inconsistent In Their Interest-Only Conversations

Building on yesterday’s post which discussed the interest-only loan debt trap, today we show that lenders are having quite varied conversations with their borrowers.

We took a cross section of households who have interest-only loans, and mapped their experience to a selection of specific lenders, looking at whether there was, as part of the purchase or refinance discussion, any explicit exploration of how the capital amount was to be repaid. Remember this is looking at the transaction from the perspective of the household, not the lender.

The average is that 43% of households with interest-only loans had an explicit discussion, but whilst some lenders achieved a score above 90%, others were much lower. A wide variation. The policy as set out by APRA is not being universally applied.

We also found that newer loans are more likely to be funded in the context of an explicit capital repayment discussion, whereas older loans were less likely to include such a discussion. This, we think, reflects lenders reacting the regulator guidance in the past couple of years. But there is clearly more to do.

It also reinforces the point there is a cadre of loans shortly to come to reset and review, where householders suddenly find they are asked some hard questions about capital repayment – perhaps for the first time. If they do not pass muster, an interest-only loan may not be available, forcing them to move to another lender (if available), or different loan structure, where repayments to principle are included. This could get quite nasty.

Should, we ask, lenders be contacting borrowers, outside the review cycle, to preempt the problem? Unless they have a watertight record of an explicit capital repayment discussion, we think they should.

The Interest-Only Loan Debt Trap

Today we discuss some specific and concerning research we have completed on interest-only loans. Less than half of current borrowers have complete plans as to how to repay the principle amount.

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

But what is happening at the coal face? To find out we included some specific questions in our household survey, and today we present the results.

Next time we will delve further into the interest only mortgage landscape, because we found the policies of the lenders varied considerably.

ASIC on mortgage brokers’ interest only loans

ASIC says the volume of interest only loan approvals rose significantly in the June 2016 quarter. But Australia’s home loans industry has improved its performance over the past year, adopting better ‘responsible lending’ practices, though there is still room for improvement.

ASIC has released its report (REP 493) ‘Review of interest-only home loans: Mortgage brokers’ inquiries into consumers’ requirements and objectives’ on the responsible lending practices of 11 large mortgage brokers with a particular focus on how they inquire into and record consumers’ requirements and objectives.

It also examined how the changes implemented by lenders in response to the findings from ASIC’s report into interest-only home loans from 12 months ago last year (refer: Report 445) have flowed through to mortgage brokers.

Since the release of Report 445 in August 2015,

the percentage of new home loans approved by lenders which are interest-only has decreased by 12%; and

the amount that can be borrowed by an individual consumer through an interest-only home loan has decreased, as lenders have adjusted their assessment of consumers’ ability to repay, in line with ASIC’s recommendation in Report 445.

Information provided by the mortgage brokers showed that for the six months from July 2015 to December 2015,

the number of new interest-only home loans fell by 16.3%, with total value of these loans reducing by 15.6%; and

the percentage of interest-only loans with a term greater than five years reduced by more than half, from 11.2% to 5.1%.

Almost 80% of applications reviewed included a statement summarising how the interest-only feature specifically met the consumer’s requirements and objectives. This compared favourably with Report 445’s finding that more than 30% of applications reviewed showed no evidence the lender had considered whether the interest-only loan met the consumer’s requirements.

‘It is vital that mortgage brokers understand consumers’ requirements and objectives to ensure they are not placed in unsuitable credit contracts,’ said ASIC deputy chairman Peter Kell.

‘ASIC is pleased that our concerns about interest-only loans and responsible lending are being acted on by the home lending industry, but there is still room for improvement.’

ASIC identified practices that place brokers at increased risk of non-compliance with their responsible lending obligations, and identified opportunities for brokers to improve their practices. Key compliance risks identified included:

Policies and procedures—Mortgage broker policies and procedures provided only general information, rather than tailored information on specific products and loan features that may impose increased financial obligations or restrict repayment flexibility (such as interest-only home loans);

Recording of inquiries—Record keeping was inconsistent and in some cases records were fragmented and incomplete;

Explaining the loan choice—More than 20% of applications reviewed did not include a statement explaining how the interest-only feature of the loan specifically met the consumer’s underlying requirements and objectives. The level of detail in these statements varied considerably and in some cases, where an interest-only loan was specifically sought by a consumer (including where this option was recommended by a third party, such as an accountant), the reason for this was not clear;

Consumer understanding of risks and costs—In some cases, where the potential benefit of the interest-only loan depended on the consumer taking specific action (for example, allocating additional funds to higher interest debt), it was unclear whether the consumer understood the potential risks/additional costs if the specific action was not taken.

The report details steps that mortgage brokers should take to improve their current practices, including:

Ensuring they understand the consumer’s underlying objectives for requesting specific loan products and features;

Recording concise summaries of consumers’ requirements and objectives and the reason why a particular product, features and lender was chosen;

Providing a statement summarising the broker’s understanding of the consumer’s requirements and objectives, which could also include the reason a particular loan is suggested, for the consumer to confirm before obtaining a loan.

Where the potential benefits of a loan feature might require the consumer to undertake specific behaviour, ensuring consumers were aware of the action they needed to take to obtain the potential benefit, as well as the potential costs should this action not be taken.

ASIC helps consumers to understand risks of interest-only mortgages

ASIC has released a suite of online tools to help consumers better understand the risks of interest-only mortgages, to complement its review of loan providers’ compliance with responsible lending laws.

The new tools, available on ASIC’s MoneySmart website at moneysmart.gov.au, include:

an interest-only mortgage calculator to help consumers work out the real cost of an interest-only home loan, and
an interest-only loan infographic that shows the journey of borrowers who take out different types of mortgage.

ASIC Deputy Chairman, Peter Kell, said while ASIC’s review had found that banks and other lenders needed to lift their game to ensure compliance with responsible lending obligations, consumers can help themselves by doing their homework before taking on such a large financial commitment.

‘For most Australians, a mortgage is one of the most significant financial decisions they will make in their lives,’ Mr Kell said.

‘While an interest-only mortgage may be attractive due to their initial lower repayments, they generally cost more in the long run. Some lenders have also started charging higher interest rates on interest-only mortgages compared to principal and interest mortgages.

‘Anyone thinking of taking out an interest-only mortgage needs to have a clear plan of action when the interest-only period ends to ensure they can afford the repayments, which may increase significantly,” said Mr Kell.

Mr Kell suggests consumers who are considering an interest-only mortgage, or who already have one at present, should consider the following:

ensure you can afford the increased repayments once the interest-only period ends, and also factor in an interest rate rise
the principal of the loan will not reduce while you are making interest-only repayments
using an offset account to reduce the cost of an interest-only mortgage will only work if you can keep making these extra repayments without making any withdrawals. If you are tempted to dip into your offset account, then you might be better off with a principal and interest mortgage instead.

ASIC’s recent probe into interest-only mortgages reinforced the fact that lenders and brokers need to meet responsible lending obligations and ensure the interest-only loans they arrange meet their customers’ requirements and objectives.

‘We expect that lenders and brokers arranging interest-only mortgages would do so in a way that is consistent with their customers’ plans,’ Mr Kell said.

Background

On 20 August 2015, ASIC released a report of its review into how lenders provided interest-only mortgages to both investors and owner occupiers (refer: 15-220MR). The review found that lenders providing interest-only mortgages needed to lift their standards to meet important consumer protection laws.

ASIC’s MoneySmart website provides trusted and impartial guidance and online tools for Australians on issues relating to money and finances. Visit ASIC’s MoneySmart at moneysmart.gov.au.

Australia is currently experiencing low interest rates. Consumers should build in a buffer over the minimum repayment for any interest rate rises and increases in repayments, especially if they have taken out an interest-only mortgage.

Example: $500,000 mortgage over 30 years with a constant interest rate of 6%

For a principal and interest loan, a consumer would pay around $582,274 in interest over the life of the loan.
For an interest-only loan with a 5-year interest-only period, a consumer would pay around $619,493 in interest (an extra $37,219 over the life of the loan) and have to find an extra $332 per fortnight in repayments after 5 years.
If the interest-only period was extended to 10 years, a consumer would pay around $662,720 in interest (an extra $80,446 over the life of the loan) and have to find an extra $498 per fortnight in repayments after 10 years.

Example image from ASIC’s MoneySmart interest-only calculator

Moneysmart Interest Only