Due to increasing regulatory pressure, the major banks have been hiking their interest-only home loan rates. This in turn is creating financial stress for some of the most vulnerable mortgage borrowers.

While analysts, the media, and Australia’s governments regularly characterise those who take out interest-only loans as affluent property investors, the truth is, many owner-occupiers who’ve taken out such loans are using them to finance the purchase of the family home. Many of these borrowers are resorting to interest-only loans because their cash flow isn’t sufficient to repay interest and principal. 

Banks are feeling the heat

The banks are under regulatory pressure to convert their interest-only borrowers into interest-and-principal borrowers, and are offering little to no fees to switch over. The catch is that monthly repayments will be higher in most cases because the mortgage borrower also has to repay principal. Those who can afford to switch will likely do so, but there will be many who will be forced to remain on interest-only and will have to bear the brunt of the rate increases.

On Tuesday, Commonwealth Bank of Australia (CBA) hiked its interest-only home loan rates by 30 basis points. The move follows similar actions by its three main rivals: Australia and New Zealand Banking Group (ANZ), National Australia Bank (NAB), and Westpac Banking Group. It was also the second out-of-cycle rate hike by one of the Big Four in just three months.

For the banks, the positive effect of the rate increases on interest-only loans will significantly outweigh the negative impact of the small drop in rates on interest-and-principal loans.

Indeed, Westpac, which has the highest proportion of interest-only loans among its rivals, could boost its earnings by 3.5%, according to research from Macquarie.

Regardless of the type of borrower, the overall effect of this latest round of interest rate adjustments will be to improve bank earnings, as borrowers will have to pay more.

Young families most at risk

Martin North, principal of Digital Finance Analytics (DFA), said younger families are one of the segments most at risk due to the rate adjustments. These are typically first-home buyers who’ve pushed their finances to the limit to enter the property market.

Both North and the analysts at Macquarie said the flow-on effects from the rate rises, even on just interest-only loans, and the potential for some to switch over to interest and principal, could be damaging for the wider economy.

“The increase to [interest-only] loans combined with the increased likelihood of customers switching to [principal and interest], in our view, will ultimately lead to further reductions in disposable incomes and put even greater pressure on highly indebted households. We estimate that a 50 basis point increase in interest rates has a 4 to 10 per cent impact on disposable income of highly indebted households,” Macquarie said. “While it would rationally make sense for many households (particularly for owner-occupiers) to switch to [principal and interest] …. many of these households would not have the capacity to do this.”