RBA sees potential concern as borrowers move from IO back to principal and interest over next four years

RBA sees potential concern as borrowers move from IO back to principal and interest over next four years
RBA sees potential concern as borrowers move from IO back to principal and interest over next four years

Almost half a trillion dollars in interest-only (IO) mortgages will convert to principal and interest loans over the upcoming four years, according to the Reserve Bank of Australia.

The Reserve Bank estimates around $120 billion in loans will convert to the more traditional principal and interest loans every year between now and 2021.

Despite the large increases in repayments when IO loans reset - officials estimate they will leap by up to 40 per cent - the Reserve Bank believes most borrowers "should be able to afford the step-up in mortgage repayments" because they have accumulated substantial prepayments.

The RBA published figures last Friday showing that around 30 per cent of all outstanding national mortgage debt will be subject to the IO reset.

Some commentators have likened ths forthcoming transition to the wave of adjustable-rate loans that triggered the 2008 US subprime crisis.

While the Reserve Bank has always downplayed the likelihood of any US-style disaster, it admitted the resets are an "area of potential concern".

It is not the first time the RBA has raised the issue as in February the Reserve Bank deputy governor Michele Bullock warned negatively geared property investors with interest-only loans posed a growing threat to Australias financial system.

Officials noted in Friday's statements that many households should be able to manage the adjustment given they are ahead with their repayments.

There are around 1.46 million outstanding interest-only mortgages.

The warning came just days after the Reserve Bank governor Philip Lowe warned Australian borrowers that a likely official interest rate hike will come as a shock to some households given they haven't seen one in seven years.

The IO reset risk numbers peaked in 2014, banks encouraged property investors to supercharge their borrowing power by taking out loans in which the principle typically isn't repaid for the first five years.

The loans were then taken up by home buyers too.

Given the interest rate on IO loans has risen, the RBA noted switching was already underway voluntarily.

But some banks also noted an increase in arrears among some borrowers switching to principal & interest (P&I) loans at the expiry of the IO period of their loans.

"Partly, this was borrowers taking time to adjust to the higher required repayments (given they would then include principal) but most subsequently returned to meeting their payments in full," the bank noted

However it was only for a small share of borrowers higher arrears.

"Borrowers voluntarily switching before the IO period expiry – to take advantage of the lower interest rate on P&I loans – were meeting the higher repayments," the RBA noted.

IO loans have been restricted by regulators in two waves of macroprudential restraints - in 2014 and 2017 - amid concerns they were stoking dangerous housing market conditions especially in Sydney and Melbourne.

The issuance of interest-only loans had fallen to around 30 per cent of borrowing by investors.

Last month to was noted brokers are writing significantly fewer interest-only loans as borrower demand plummets.

Mortgage Choice has revealed the proportion of interest-only (IO) mortgages written by its brokers fell by more than 20 per cent in the 12 months leading to February 2018.

IO loans accounted for 12.22 per cent of all home loans written in February 2018, down by 23.73 per cent to 35.95 per cent.

The serviceability assessments used to write IO loans incorporate a range of buffers, the RBA noted in the latest Financial Stability Review, published on Friday.

The bank suggested share of borrowers who cannot afford higher P&I repayments - who might not be eligible to alleviate their situation by refinancing - was thought to be small.

"In addition, borrowers who are in this situation as a result of past poor lending practices may be eligible for remediation from lenders."

The RBA noted one important aim was to address the risks posed by the concentration of mortgages on banks’ balance sheets, which have increased in recent years to now account for more than 60 per cent of total loans.

APRA is proposing to raise the minimum amount of capital that must be used to back residential mortgages, relative to other loans.

In addition, APRA proposes to make risk weights on mortgages more sensitive to risk. Risk weights would distinguish between P&I mortgages to owner-occupiers and all other mortgages (which would require more capital), and risk weights for ADIs using the standardised approach would also be more sensitive to the outstanding LVR.

Jonathan Chancellor

Jonathan Chancellor

Jonathan Chancellor is one of Australia's most respected property journalists, having been at the top of the game since the early 1980s. Jonathan co-founded the property industry website Property Observer and has written for national and international publications.

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