The coming crisis with interest-only loans

Interest-only loans, which postpone the repayment of the loan principal for a fixed term, usually between three to five years, have been targeted by financial regulators, including the Australian Prudential Regulation Authority (APRA) and the Reserve Bank of Australia (RBA).

These institutions are worried that low repayments are fuelling growth in Australia’s hottest real estate markets by encouraging property buyers to take on unsustainable levels of debt.

Recent increases in interest rates on investor loans, usually by about 60 basis points, have impacted investor cash flow, and the expiration of fixed terms is encouraging many to consider switching to principal-and-interest repayments.

Further compounding the issue, there are growing concerns that some borrowers switching from fixed terms might not be able to service higher repayments, or meet lenders’ serviceability thresholds, which usually range from 7% to 7.25%.

Large monthly repayments are forcing many investors to extend their interest-free terms, or find alternative means of boosting cash flow, such as hiking rents or selling their properties.

Michele Bullock, assistant governor (financial system) for the Reserve Bank, recently highlighted the “large proportion” of interest-only loans set to expire between 2018 and 2022. She warned that some borrowers would not be able to meet “more conservative” lending standards.

Many of these loans were taken out before APRA imposed caps on the speed and volume of interest-only loan growth in December 2014.

Members of the Big Four, including Australia and New Zealand Banking Group (ANZ), are reviewing their assessment of existing interest-only loans as large numbers of loan terms near their expiration.

From March 5, ANZ will define all interest-only loan renewals as “credit critical events” requiring full income verification to ensure that borrowers will be able to meet prudential standards for income and debt.