Interest-only loans: The big idea
A few people have had questions for me on interest-only mortgages of late, so I thought I'd do a quick 'back to basics' post to explain why they are useful and so popular, and some of the possible disadvantages.
As the name implies if a bank writes a mortgage on interest-only terms, this means that the borrower initially pays an interest charge on the amount borrowed but doesn't pay down the balance of the loan.
Why would you do that?
Well, it makes an awful lot of sense for an investor.
That's because the initial repayments may be lower, and all of the interest may be tax deductible.
But here's the clever part: you can combine your everyday savings or transaction account with your mortgage into an offset account, so your savings can reduce the amount of interest you pay on your loan.
Very simple, and very effective.
So it makes perfect sense for an investor, it's highly tax-efficient, and since it allows you to build up a nice buffer in case of a rainy day it's also a safer way to borrow for sensible investors.
The risks
There seems to be an increasingly prevailing view or rebuttable presumption that interest-only loans are 'bad' and/or riskier.
But as you can see above in many ways an interest-only loan can be less risky, since it encourages smart borrowers to build up mortgage buffers.
And in fact in aggregate this has happened to an unprecedented degree in Australia, even if some borrowers have not been quite so prudent.
Where risks can arise is when the borrower reaches the end of the interest-only period - typically five years - and where they may have become so used to repaying only the interest that the extra repayment of principal comes as something of a shock.
The risk is increased if the borrower has multiple interest-only (IO) loans resetting at the same time, or if they have borrowed more than they can comfortably afford.
The risks may also be higher where dwelling prices have been falling and the borrower has not made inroads into paying down the mortgage, such as in Western Australia.
Paradoxically the clampdown on IO lending also increased risks for a time, because it became significantly tougher for borrowers to seek lower mortgage rates or different products elsewhere, effectively trapping them into their present deal.
Whereas a sensible lending environment would allow a stressed borrower simply ask to postpone repayments for an agreed period or to extend the IO period, this has not always been an option for some borrowers.
A few years ago IO loans became very popular, and this stampede led to a clampdown on the widespread use of these terms.
Most borrowers have managed the reset comfortably thanks to their buffers and ongoing low mortgage rates, but there has been a small increase in mortgage arrears lately.
The impact has mainly been on investors, though not exclusively, as some homebuyers took out interest-only loans too.
And the impact has been felt most keenly in Western Australia where the economy was already weakened, but there has been an impact across the board.
Fortunately most loans today are assessed very conservatively, ensuring that the higher repayment at the end of the IO period can comfortably be afforded, and it's also become much harder to get multiple loans for the average or marginal borrower.
The outlook
Some years ago I wrote a paper on 'the interest-only cliff', running some scenarios on what night happen if too many borrowers are pushed on to principal and interest repayments at the same time.
Banks had introduced a mortgage rate differential (nice work if you can get it!) so that IO borrowers paid considerably higher rates for these products.
I'm hopeful that we have now been through the worst, with the regulatory cap on interest-only loans now having been lifted.
I don't have a crystal ball, but it seems to me that the quantum of interest-only loans should stabilise, albeit at a much lower level (it's actually a much smaller share of a much smaller mortgage pie).
One of the major banks has been angling for new business through offering rates of a tick under 4 per cent IO plus a cash rebate for new customers bringing loans across, and others may now allow the interest-only period to be extended out to a maximum of ten years without triggering complicating new credit assessments.
Shayne Elliott of ANZ, still another of the major banks, said that lending standards are now easing back towards a sensible equilibrium (and indeed ANZ introduced new and more favourable IO terms recently too).
It was only last month that Royal Commission final report was handed down, but it does seem that there will be some gentle relaxation at the margin - mainly through brokers, and with little fanfare - which hopefully should help to act as a pressure release valve.
The mechanically forced reset now longer applies, and lenders should have no interest in pushing the marginally stressed borrower into arrears unduly.
