One in three interest-only borrowers don't understand their loans: UBS

A third of customers with interest-only home loans may not properly understand the product and could end up in stress once they start paying back the principal, according to investment bank UBS.

Typically, a borrower has to pay only the interest component of a loan when he takes out an interest-only loan for the first five years. After that, monthly payments go up as the borrower also starts paying back the principal.

The new analysis by UBS concluded that borrowers would be exposed to financial stress once their monthly payment jumps. 

The findings are based on a survey the bank conducted between July 7 and August 4 this year seeking responses from borrowers who took out a home loan within the previous 12 months.

UBS found only 23.9 per cent of 907 respondents had an interest-only loan, compared with economy-wide figures that show 35.3 per cent of loans are interest-only, Fairfax Media reported.

Lead analyst Jonathan Mott noted that he initially suspected the survey sample had an error, but now believed a "more plausible" reason was that interest-only customers did not properly understand their loan.

We are concerned that it is likely that approximately one third of borrowers who have taken out an interest-only mortgage have little understanding of the product or that their repayments will jump by between 30 and 60 per cent at the end of the interest-only period (depending on the residual term)," he was quoted by Fairfax Media as saying.

UBS quoted surveys by ME Bank to show many Australians have an apparent lack of financial literacy and understanding of home loan products, with 38 per cent admitting they had "no understanding of interest-only repayments".

He also cited a 2014 Standard & Poor's report that said 64 per cent of Australian adults were financially literate, implying 36 per cent were not.

The survey follows another one by UBS which revealed that there were $500 billion of “liar loans”, meaning they were written based on inaccurate information provided by borrowers in their application.

UBS said that over 70 per cent of survey respondents that took out an interest-only loan said they were "under moderate to high levels of financial stress".

"While these loans are well secured, we believe many borrowers may face substantial stress as interest rates rise or when they revert to principal and interest," UBS wrote.

UBS pointed out that mortgage misselling and irresponsible lending could have contributed to the problem.

The survey also suggested that borrowers would cut their spending (50 per cent) or begin paying down principal (24 per cent), once the higher payments start.

It also noted that the moves by the banks to increase interest rates on interest-only mortgages provided a "substantial" boost to their margins.

Interest-only loan rates have increased by an average of 74 basis points for investors, to 6.26 per cent and 49 basis points for owner occupied borrowers over the last 12 months to 5.78 per cent.

It comes as banks have responded to regulators asking to restrict interest-only loans to 30 percent as the property sector is increasingly being seen as a risk to the economy.