One of the more concerning trends in the home-loan market lately has been the strong growth in interest-only lending.
The share of new loans that are interest-only has climbed from about 30 per cent six years ago to 43 per cent today, the second-highest level on record.
If you’re thinking about joining the growing number of people borrowing in this way, especially if you plan to live in the house, it’s important to be aware that it is a riskier type of loan and to take extra care.
Interest-only loans, which are mainly used by investors, allow a borrower to not pay back any principal for anywhere between five and 15 years.
This means the monthly cost of an interest-only mortgage is initially lower. Or, it can mean a borrower is able to service a larger loan than they would have otherwise.
But don’t be fooled by the appearance of lower costs, or an ability to service a larger debt. Anyone who is only paying interest on a loan, especially if they live in the house, needs to be aware that there are extra risks of borrowing in this way.
Interest-only loans have traditionally been most popular with property investors because they are able to deduct their interest payments against other income. That’s one reason why their share has shot up recently – investors are driving the market.
However, the Australian Prudential Regulation Authority has recently warned about the growth of interest-only lending to owner-occupiers, which it sees as a form of “higher-risk” lending.
The Australian Securities and Investments Commission is also scrutinising the banks to make sure they’re not breaking responsible lending laws in this area.
What’s got the watchdogs so concerned?
Well for one, if you only pay interest on your loan, you’re at greater risk of being in “negative equity” if property prices fall. That’s the uncomfortable position where your debt is worth more than the home itself.
With a principal and interest loan, a borrower making the minimum monthly payments will typically have paid off about 10 per cent of their loan in the first five years, so they have a buffer if property prices do fall. Anyone only paying interest lacks this buffer.
Another key point to remember is that interest-only loans typically have a limited time limit, and revert to being interest and principal after five years, pushing up the monthly costs.
Finally, there’s a risk these products can be mis-sold by banks or mortgage-brokers in an overheated market where interest rates are at record lows.
In the boom years before the global financial crisis, interest-only loans were more likely to be offered to sub-prime borrowers and those with little documentation. They were also more likely to default.
In short, it is exactly the type of extra risk-taking that has got the regulators eyeing the housing market nervously.