Interest Only Loans – Time Bomb or Hiccup?

Over recent months it has been very noticeable that banks have been increasing interest rates and tightening credit policy for interest only loans, regardless of whether they are for Investment or Owner Occupation.

The appetite for interest only lending has diminished significantly and through pricing and policy banks are encouraging borrowers to consider principal and interest repayment options.

What has happened?
In March 2017 APRA wrote to all ADI’s (Approved Deposit Taking Institutions) advising that it viewed that “further steps to address risks that continue to build within the mortgage lending market are appropriate”.

A key factor imposed was to limit the level of new interest only lending that ADI’s were undertaking. There was an expectation that ADI’s would begin to self impose internal limits and closely monitor interest only lending at higher Loan to Valuation Ratios (LVR). There was also an expectation that serviceability metrics, such as interest rate and net income buffers were reviewed.

The letter highlighted that it was expected that ADI’s immediately took steps to address several mortgage lending issues identified in the letter.  It is also understood that lending limits for interest only lending were introduced.

Compounding the issue was the understanding that many Banks were already at levels well over the lending limits expected by APRA.

What has changed?
While there are many perfectly sound strategies for borrowers to request Interest Only Loan facilities, the broad brush approach of the regulators did not distinguish between sound and unsound strategies.

For example many property investors have historically utilised a strategy of taking out interest only investment loans to maximise tax deductible debt, while utilising any surplus income to reduce non tax deductible debt (i.e. their owner occupied home loan). This is structure supported and recommended by many financial advisers.

The regulators clearly have concerns that interest only borrowings may not be appropriate in all a cases in the current environment. Particularly an environment that includes low interest rates, rising household debt and higher house prices. They have therefore imposed industry wide restrictions to encourage what they consider to be more prudent levels of interest only lending.

The Banks have reacted quickly, as expected by the regulators. Interest only interest rates have experienced further out of cycle interest rate increases, and this increase is even more substantial for Investment Loans with interest only repayments. In many cases interest rates now have a very significant premium for those seeking Interest Only repayments.

Credit policies have also been further tightened reducing the availability of lending at higher LVR’s and in many cases reducing applicants borrowing power and maximum LVR. A maximum interest only LVR of 80% is now common.

What now for Interest Only borrowers?
The impact to Interest Only borrowers depends on their current individual circumstances

If you are looking to purchase a property with interest only repayments, but have not reviewed your borrowing capacity or loan costs in recent times, I would suggest you again enquire with your Lender or Mortgage Broker.

If you are an existing borrower with variable rate investment loans, chances are you have already experienced increases in interest rates. Now might be a good time to consult with a Mortgage Broker on potential interest savings and cash flow impacts to convert to a Principal and Interest repayment program.

If you are currently in a fixed interest rate term, you have avoided the immediate increases, but need to be aware of, and start planning for the potential increase in rates and repayments at the expiry of your fixed rate.

If you have an impending expiry date of your current interest only term, you need to be aware that your lender may not be willing to extend your interest only term beyond the current expiry date, and may impose Principal and Interest repayments that will impact your household cash flow. Many borrowers need to start planning for that increased higher repayment now.

Are there other options?
The positive news is that borrowers still do have options. While most ADI’s have tightened borrowing controls and interest rates for interest only borrowers, they have done so at different levels depending on their current loan portfolio.

It is also noted that not all lenders are ADI’s that are monitored by APRA, and while these lenders might be maintaining prudent lending standards, their interest rates and terms may not have been impacted to the same level.

So in the current environment if you are not happy with your current loan you simply need to dedicate the time to shop around and find a more suitable lender for your needs.
With the widespread changes this could take considerable time, so the other option is to consult your local Mortgage Broker who deals with a broad number of lenders and can do the researching for you, and provide advice on potential options.

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