Interest-only mortgage glut sparks default risk

The high level of interest-only mortgages in the Australian economy has led one global fund manager to flag negative equity risks for borrowers and question the effectiveness of macroprudential tools.

Standard Life Investment's latest weekly economic briefing looks at the levels of debt across a number of major economies, including Australia.

The report, authored by a handful of top forecasters including former Reserve Bank senior economist Jeremy Lawson, says APRA’s concerns around interest-only home loans are “well founded”.

“In Australia, policymakers have been locked in a battle against household leverage for many years, with household debt-to-GDP rising above 120 per cent — ranking number one globally. In particular, the Council of Financial Regulators and the APRA have been vocal of late about the risks posed by interest-only loans and investor lending,” it said.

Standard Life pointed to the RBA’s latest Financial Stability Review, which shows that interest-only (IO) loans account for 23 per cent of total owner-occupied loans and 64 per cent of investor loans.

“It is the recent uptick in these IO loans, particularly the latter category, which has caught the regulator’s eye,” the report said. “The concern is well founded. Given their structure, IO loans result in a higher average level of indebtedness over the life of the loan than a typical principal and interest payment loan.

“Consequently, borrowers are more susceptible to falling into negative equity in the event of a housing price decline, while higher required payments at the end of an IO loan period increases the risk of default. To make matters more awkward, it is exactly these types of loans that macroprudential tools were used to target in late 2014.”

While the initial response to APRA’s 2014 measures, such as higher interest serviceability requirements, was encouraging, Standard Life warned that the recent resurgence in these loans raises questions about the effectiveness of these measures in the medium term.

“The latest Financial Stability Review certainly increases pressure on banks to rein in excessive risk and lenders are already responding, with out-of-cycle mortgage-rate hikes and tougher loan serviceability tests,” it said.

“However, the persistence of IO and investor loan growth is likely to continue to increase vulnerabilities in the Australian housing market.”

[Related: APRA announces further measures on investor lending]

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