Interest-only borrowers take bigger financial risks

The latest findings from Morgan Stanley’s AlphaWise research arm shows that interest-only mortgage borrowers tend to be less competent money managers and exacerbate risks for financial institutions.

A propensity for spending their way further into debt and reducing savings when faced with higher costs, as well as a tendency to sell their properties if interest rates rise, make interest-only borrowers a higher risk, according to Morgan Stanley analysts Richard Wiles and Andrei Stadnik.

“Interest-only mortgage holders are saving less than principal-and-interest customers,” the analysts said. “[The risk] gap is particularly large among owner-occupiers, where [around] 20 per cent of interest-only loan holders would consider selling versus around 5 per cent of principal and interest (P+I) borrowers, suggesting that being on interest-only is a risk flag.”

Interest-only buyers carry two main risks: First, rather than making financial sacrifices (such as dipping into savings or cutting back on expenses), interest-only borrowers are more likely to sell their properties if rates rise. Should the real estate market experience a slowdown, a glut of properties dumped on the market by panicked borrowers could precipitate a crash.

Second, interest-only home loan borrowers are more likely to take on even more debt to manage higher costs, with more than half (53%) saying they’re likely to use credit cards or consumer finance to make ends meet. In contrast, only 29% of principal-and-interest borrowers said they would likely take this route.

This is worrying for the industry, because interest-only borrowers’ mortgage payments are already around 40% lower than those made by principal-and-interest borrowers on average, according to the report.

“This is consistent with our findings that interest-only mortgage holders are saving less than P+I customers, with this gap most pronounced for owner-occupiers,” the analysts said.

Wiles and Stadnik said the Australian Prudential Regulation Authority (APRA) could amplify its crackdown on interest-only residential mortgages after limiting the amount banks can have on their balance sheets earlier this year.  

Wayne Byres, chairman of APRA, recently urged lenders at a business conference in Sydney to ensure that their policies and practices are both “prudent and responsible”.

“Household indebtedness is high. Perhaps more importantly, the trajectory is clearly for it to rise further,” he said. “Heightened risk requires heightened prudence by APRA but also — and preferably — by lenders and borrowers themselves.”