Tag: Interest Only Loans

Interest Only Loan Assessments Falling Short – ASIC

ASIC today released a report that found lenders providing interest-only mortgages need 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.

ASIC’s probe into interest-only home loans was announced in December 2014 and looked at 11 lenders, including the big four banks, to assess how they are complying with responsible lending laws.

As the national regulator for consumer credit and responsible lending, ASIC identified that demand for interest-only loans had grown by around 80% since 2012. ASIC’s review looked at how consumers were assessed for loans by lenders with a focus on the affordability of the loans over the longer term.

The review found that interest-only loans are more popular with investors and those on higher incomes, and that delinquency rates are currently lower for interest-only home loans.

However, ASIC also found that lenders have been falling short of their responsible lending obligations in the provision of interest-only loans. Lenders are often failing to consider whether an interest-only loan will meet a consumer’s needs, particularly in the medium to long-term.

Their key findings from the data review were:

  1.  The majority of interest-only home loans were extended to investors; however, a substantial proportion of interest-only home loan approvals (41% in the December 2014 quarter) were for owner-occupiers.
  2. A greater proportion of the total number of interest-only home loans was sold through third-party or broker channels, compared to direct channels
  3. The average value of interest-only home loans was substantially higher than principal-and-interest home loans for both owner-occupiers and investors, and this was especially so for loans provided through direct channels in comparison with third-party channels.
  4. Overall, there was a smaller proportion of interest-only home loans in higher LVR categories when compared to principal-and-interest home loans
  5. A diverse group of consumers tended to take out interest-only home loans. In general, interest-only home loans were more popular with consumers who earned more money, but a substantial proportion (29%) of owner-occupiers with interest-only home loans earned less than $100,000
  6. Consumers with interest-only home loans were, on average, further ahead in reducing the balance of their loan when including funds held in offset accounts related to the home loan, than those with principal-and-interest home loans.

ASIC’s review of more than 140 consumer loan files from bank and non-bank lenders identified:

  • In 40% of files reviewed, the affordability calculations assumed the borrower had longer to repay the principal on the loan than they actually did
  • In over 30% of files reviewed, there was no evidence that the lender had considered whether the interest-only loan met the borrower’s requirements
  • In over 20% of files reviewed, lenders had not considered the borrower’s actual living expenses when approving the loan, but relied instead on expenditure benchmarks.

These practices can expose borrowers to not being able to afford their loan repayments in the future, particularly for interest-only loans, which have much higher repayments after the initial interest-only period ends.

ASIC also issued a survey to the 11 lenders to gain valuable data about the growth of interest-only home loans. The findings are detailed in Report 445, Interest-only home loan review (REP 445).

ASIC Deputy Chair Peter Kell said, ‘Interest-only loans may be a reasonable option for some borrowers. However, lenders must have robust processes in place for assessing a customer’s ability to afford a loan, taking into account the increased repayments once the interest-only period ends. They should lend responsibly, and in a way that does not result in consumers taking on debt that they cannot afford, especially if interest rates rise.’

The report makes a number of recommendations that lenders and brokers should review to ensure they are complying with responsible lending obligations. Following ASIC’s review, all 11 lenders have changed their practices in line with ASIC’s recommendations or have committed to implementing necessary changes in the coming months. The recommendations include ensuring:

  • loans align with consumers’ requirements and objectives
  • lenders use a consumers’ actual expenses rather than relying on a benchmark
  • affordability assessments include buffers for future interest rate rises.

Mr Kell said, ‘We are pleased that the lenders involved in the review have already started implementing changes based on our findings. The rest of the lending industry, including brokers, should  now take note and swiftly review the practices they have in place to ensure they comply with their responsible lending obligations.’

As a result of this review, ASIC has commenced follow-up investigations in certain cases which are ongoing. Where necessary, ASIC is considering enforcement action or other regulatory action.

ASIC To Investigate Interest-Only Loans

In a parallel announcement, ASIC will conduct a surveillance into the provision of interest-only loans as part of a broader review by regulators into home-lending standards. The probe will look at the conduct of banks, including the big four, and non-bank lenders and how they are complying with important consumer protection laws, including their responsible lending obligations. The review follows concerns by regulators about higher-risk lending, following strong house price growth in Sydney and Melbourne.

Through the Council of Financial Regulators, ASIC, APRA, the Reserve Bank of Australia (RBA) and the Treasury are working together to monitor, assess and respond to risks in the housing market. Interest-only loans as a percentage of new housing loan approvals by banks reached a new high of 42.5% in the September 2014 quarter (this includes owner-occupied and housing investment loans). ASIC Deputy Chairman Peter Kell said, ‘While house prices have been experiencing growth in many parts of Australia, it remains critical that lenders are not putting consumers into unsuitable loans that could see them end up with unsustainable levels of debt. ‘Compliance with responsible lending laws is a key focus for ASIC. If our review identifies lenders’ conduct has fallen short, we will take appropriate enforcement action.’

Background

The Australian Prudential Regulation Authority (APRA) announced today it has written to all authorised deposit-taking institutions (ADIs) to set out plans for a heightened level of supervisory oversight on mortgage lending in the period ahead. See the earlier DFA post in relation to this.

With interest-only loans, a borrower’s repayment amount will only cover the interest on the loan. The principal amount borrowed will not reduce unless the borrower chooses to make extra repayments. Paying interest-only means that a borrower will pay more interest over the term of the loan. Some borrowers choose interest-only loans to maximise the amount they can borrow, especially if it is for investment purposes. Loans are usually only interest-only for a set period of time, after which the borrower will either need to increase their repayments to start reducing the principal, or repay the loan in full.

Although interest-only loans can be appropriate in the right circumstances, interest-only loans can raise a number of risks, such as:

  • Whether the borrower can only afford a loan because it is interest-only
  • Whether the borrower can afford principal and interest repayments at the end of the interest-only period, and
  • Whether the borrower understands the impact of not making principal and interest repayments.

The responsible lending obligations require credit licensees to ensure that consumers are only placed in credit contracts that meet their requirements and objectives and that they can meet their repayment obligations without substantial hardship. In doing this, credit licensees must make reasonable inquiries into an individual consumer’s specific circumstances and take reasonable steps to verify the consumer’s financial situation.

In August 2014, the Federal Court handed down its first decision on the responsible lending obligations: ASIC v The Cash Store (in liquidation) [2014]. The Federal Court’s decision made it clear credit licensees must, at a minimum, inquire about the consumer’s current income and living expenses to comply with the responsible lending obligations. Further inquiries may be needed depending on the circumstances of the particular consumer.

In response, in November 2014 ASIC updated Regulatory Guide 209 Credit licensing: Responsible lending conduct to incorporate the general findings of the Federal Court on the responsible lending obligations for credit licensees. ASIC also updated RG 209 to make it clear that credit licensees cannot rely solely on benchmark living expense figures rather than taking separate steps to inquire into borrowers’ actual living expenses.