Should interest-only loans still be feared?

The Great Australian Dream has moved beyond simply owning your own home, to owning an investment property as well. But our love of bricks and mortar has led us to become the leader in household debt to GDP for G20 nations—and the only country of this group over 100 per cent.

Some economists fear that Australia’s addiction to residential property debt could see us heading towards our first recession in 27 years, in part because a large number of interest only loans are about to become due.

“When growth stumbled during the global financial crisis, the government started handing out checks to help buyers scrounge up deposits, bolstering the economy in the process,” says a 2018 report by Bloomberg.

“As the mining-investment bonanza to feed China’s demand for commodities started to splutter from 2012, the central bank rode to the rescue, cutting interest rates to record lows.”

As a result, a large number of investors took advantage of the low interest rates to buy residential property. Interest-only loans, where principal doesn’t have to be repaid for five years, peaked in 2015, with 46 per cent of all mortgages originated in that year structured in such a way.

The majority of these loans, totalling some $120 billion, will roll over to principal and interest payments between 2019 and 2022, in some cases doubling the monthly repayments.

This may sound like a recipe for economic disaster, the outlook is in fact more positive

“Anecdotal evidence from the major ADI’s [Authorised Deposit-taking Institutions] suggests that interest-only borrowers are typically wealthy and reflect a very small percentage of bad debts,” says a report into the Australian mortgage sector by SQM research.

This view is supported by the Reserve Bank of Australia. In a 2018 speech on interest-only loans by assistant governor Christopher Kent, he said that tightening of lending criteria and buffers factored into servicing calculations “implies that borrowers should be able to accommodate a notable rise in required repayments.”

Kent also noted that it is worth emphasising that rollovers to principal and interest of this size are not unprecedented. Furthermore, he believes the effect on the economy will be minimal.

“Some interest-only borrowers will be willing and able to refinance their loans. Also, many others have built up a sufficient pool of savings, or will be able to redirect their current flow of savings to meet the payments—or have planned for, and will manage—this change in other ways,” he added.

“The substantial transition away from interest-only loans over the past year has been relatively smooth overall, and is likely to remain so.”

Indeed, the financial regulator APRA recently lifted a cap it placed on new interest-only loans after 19 months to slow any flow-on effects to the property market.

“The benchmark was put in place as a temporary measure in March 2017, as part of a range of actions over recent years to reinforce sound lending practices,” said APRA chairman Wayne Byres said in a statement.

He added that the caps “have now served their purpose of moderating higher risk lending and supporting a gradual strengthening of lending standards across the industry over a number of years.”

Many analysts believe that the decision will provide a welcome strengthening of responsible lending practices by banks, as well as help bolster a cooling property market.

“APRA’s announcement provides welcome certainty and direction,” says Ken Morrison, chief executive of the Property Council.

The average price of residential property in Australia is now $675,000—still some $188,000 higher than it was six years ago.

For more on current market condition, check out what falling bond yields mean for investors.