Interest-only loans: Why all the fuss?
If you are a potential property buyer or investor, you will be aware that the banks are putting the brakes on interest-only lending. So why (and how) are the banks doing this, and are interest-only loans still a viable option for property purchasers?
If you were to approach one of the four major banks for an interest-only loan, they would apply an interest rate of up to 0.66% higher than for the same loan with a principal and interest repayment structure. They have also tightened their lending criteria for interest-only loans, making the assessment process tougher for many applicants. These changes include tightening the method used to calculate the applicant’s capacity to repay the loan, and reducing the LVR levels acceptable under this product type. They can still provide loans for those borrowers who need them, but the reality is they are now more expensive, and the qualifying conditions are tighter.
Why the fuss?
The increase in the cost of the loans, and the tighter lending policies, are all designed to reduce demand for, and supply of, this type of facility. Why? Because the banking regulator, APRA, is concerned about ‘heightened risk in the housing market’ (and the impacts on both borrowers and lenders alike) should there be a significant interest rate rise and/or a downturn in the property market.
While they are concerned with protecting the integrity and strength of Australian banks, APRA are also trying to change the borrowing habits of Australians by making interest-only loans less prevalent and are doing so via the banks. Of all new residential loans, only 30% may be written on an interest-only basis under new guidelines implemented by APRA. Lenders are now also more closely scrutinised to ensure that interest-only loans are only provided to those deemed suitable.
The banks have no option but to slow their interest-only lending. By tightening policies, they reduce the number of applicants eligible for those loans. By increasing the rates, they reduce demand, steering applicants towards principal and interest repayment structures.
This stance is perhaps long overdue, because for some time, many lenders have been too liberal with the provision of this type of loan without due regard to the risks to both themselves and their borrowers.
These risks include;
- If the loan is not reduced during the interest-only period and the property does not rise in value or indeed falls, the borrower’s equity may be reduced, or in extreme circumstances, the loan may even exceed the property value. This is a concern if there is any correction in property values (particularly in Sydney and Melbourne, where prices have skyrocketed, along with loan sizes). Perth provides a stark example of this, with the decline in property values following the end of the mining boom leaving many property owners in the red.
- When the repayments revert to principal and interest after the interest-only period, the repayments will increase significantly and may be unaffordable for the borrower. This is called “payment shock” and is a specific concern of APRA. The repayments increase for two reasons:
1. The revised payments will include a principal repayment component, in addition to the interest amount that was being paid prior to the change.
2. The principal and interest repayments are calculated on the remaining term of the loan, not the original term. So, the borrower has the same amount of debt to repay as when they took the loan, but a shorter period to do so.
Interest-only loans are still the right option for some borrowers, including;
- Investors with strong income who rely upon a negative gearing strategy.
Borrowers with reduced income capacity in the short term (e.g. those taking periods of parental leave, or career breaks) who need to minimise their loan repayments during that time.
- Borrowers looking for tax-effective structures that allow them to focus their cash flow on loans where the costs are non-deductible, such as their owner-occupied property loan, rather than investment loans where the interest is tax deductible.
- These borrowers can still access interest-only loans, but the simple fact is the application process will be more rigorous and the rate will be higher than it was before.
The primary objective of any good lender is to provide a loan structure that best matches the applicant’s needs and maximises their wealth. Interest-only loans are part of that product mix. So, if you are considering a loan with interest-only repayments, don’t let the higher price and the tougher guidelines scare you, as your circumstances may still be best suited by that type of facility. If in doubt, speak with a Switzer Home Loans specialist to identify the right structure and options for you.