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Lack of borrower understanding of IO terms ‘concerning’: UBS

The lack of borrower understanding of interest-only loan terms, especially among owner-occupier households, is “concerning”, a global investment bank has warned.

According to UBS’ Australian Banking Sector Update on 19 September, which involved an anonymous survey of 1,008 consumers who took out a mortgage in the last 12 months, 18 per cent stated that they “don’t know” when their interest-only (IO) loan expires, while 8 per cent believed their IO term is 15 years, which doesn’t exist in the Australian market.

The research found that less than half of respondents, or 48 per cent, believed their IO term expires within five years.

The investment bank said that it found this “concerning” and was worried about a lack of understanding regarding the increase in repayments when the IO period expires.

The Reserve Bank of Australia (RBA) earlier this year revealed that borrowers of IO home loans could be required to pay an extra 30 per cent to 40 per cent in annual mortgage repayments (or an additional “non-trivial” sum of $7,000 a year) upon contract expiry. The central bank noted that the increase would make up 7 per cent, or $120 billion, of the total housing credit outstanding.


According to the RBA, 2020 is the year that most of the 200,000 at-risk IO loans will reset.

UBS’ research, which was conducted between July and August this year, revealed that more than a third of respondents, of 34 per cent, “don’t know” how much their mortgage repayments will rise by when they switch to principal and interest (P&I) contracts.

More than half, or 53 per cent, estimated that their repayments will increase by 30 per cent once their IO term ends, while 13 per cent expected their repayments to rise by more than 30 per cent, which is the base case for most IO borrowers.

“This indicates that the majority of IO borrowers remain underprepared for the step-up in repayments they will face,” UBS stated in its banking sector update report.

Further, nearly one in five respondents to the UBS survey, or 18 per cent, said that they took out an IO loan because they can’t afford to pay P&I.

“With a lack of refinancing options available and the banks reluctant to roll interest-only loans, these mortgagors will have to significantly pull back on their spending, sell their property, or [they] could potentially end up falling into arrears,” the investment bank stated in its report.

UBS also found it concerning that 11 per cent of respondents said they expected house prices to rise and planned to sell the property before the IO period expires.

“This is a risky strategy given how much the Sydney and Melbourne property markets have risen, and have now begun to cool,” the investment bank said.

Overall, the top two motivations for taking out an IO loan, according to UBS survey participants, were “lower monthly repayments gives more flexibility on my finances” (44 per cent) and “to maximise negative gearing” (43 per cent).

The second motivation was selected by 32 per cent of owner-occupier borrowers who cannot benefit from negative gearing as the tax incentive applies to investors, 53 per cent of which cited this benefit.

Most banks yet to implement tighter expense checks

The investment bank reiterated in its banking sector update that it expects mortgage underwriting standards to tighten further in the next 12 months. It claimed that, contrary to comments by regulators that “heavy lifting on lending standards is largely done”, most banks are yet to fully verify a customer’s living expenses and a large number of customers are still not submitting payslips and tax returns.

“As a result, we believe there is likely to be much work required for the banks to comply with the royal commission’s likely more rigorous interpretation of responsible lending and improve mortgage underwriting standards. We expect this is likely to play out over the next 12 months,” UBS stated in its update report.

UBS went on to maintain its belief that Australia is at risk of experiencing a "credit crunch" in the next couple of years, but it is waiting on a number of “signposts” to make a more calculated judgement. These include the Hayne royal commission’s interim and final report, major bank policies around living expenses, details from the Australian Prudential Regulation Authority on debt-to-income caps, the federal election, changes in property prices, and sentiments from the RBA.

“We remain very cautious on the Australian banks,” the investment bank concluded in its update report.

“After a prolonged 26 years of economic growth, many excesses have developed in the Australian economy, in particular the Sydney and Melbourne housing market.

“We believe the royal commission creates an inflection point and credit conditions are tightening materially. Whether Australia can orchestrate an orderly housing slowdown remains to be seen, and we think the risks of a credit crunch are rising given the significant leverage in the Australian household sector.”

[Related: Switching to P&I may not have desired effect]

Lack of borrower understanding of IO terms ‘concerning’: UBS
UBS, interest only terms, owner-occupier households

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