Interest-only mortgage reset to add extra $7,000 per year, RBA says

Australian Financial Review Apr 24 2018 8:21 AM

Jacob Greber, Su-Lin Tan

Repayments for a typical Australian facing a reset of their interest-only loan to interest-and-principal will jump by around $7,000 a year - a "non trivial" increase that should, however, be managed by most households, says Reserve Bank of Australia assistant governor Christopher Kent.

Presenting analysis of the almost $500 billion in loans that are due to "reset" away from interest-only loans over the next five years, Dr Kent said the impact on household consumption overall is likely to be less than moderate.

Dr Kent said the Reserve Bank believes many interest-only borrowers will be willing and able to refinance their loans, while many others have built up a "sufficient pool of savings", or can shift savings from elsewhere to meet the higher repayments.

"Indeed, the substantial transition away from interest-only loans over the past year has been relatively smooth overall, and is likely to remain so," he told the Housing Industry Association in Sydney on TuesAround two-thirds of interest-only loans are due to have their interest-only periods expire by 2020.

"Most people are managing the transition pretty well. Non-performing loans in the past year, when many people have been switching, have not really changed very much certainly not in NSW and Victoria."

The remarks come just over a week after the Reserve Bank revealed that about 30 per cent of all outstanding national mortgage debt will be subject to the reset from interest-only loans to principal and interest loans, which some have likened to the surge in adjustable-rate loans that triggered the 2008 US subprime crisis.

Concerns that a "shock" could hit many interest-only borrowers prompted some participants at the HIA breakfast to suggest a more "staggered increase in mortgage rates" might have been a better transition.

"The important thing partly is that, if the customers are sort of understanding the products properly, and the banks are explaining the products clearly one shouldn't be in shock," Dr Kent said.

Sales of interest-only loans surged over recent years as more investors used the products to ramp up their investment in the property market

About $120 billion of interest-only loans is scheduled to roll over to P&I loans each year over the next three years.

Dr Kent said the regulatory bodies such as APRA could have controlled the rise of these loans over time, rather than acting only when the proportion of those loans had reached a critical 40 per cent of banks' loan books. These controls also include the limitation on high loan to value ratios.

"There are possibly improvements that the banks could have made" he said.

Concerns about the risks to financial stability when those loans reset - typically after five years - have prompted a series of regulatory restraints on banks, including encouraging borrowers to switch early to principal and interest loans.

The Reserve Bank estimates that around $120 billion a year in loans will be reset between now and 2

The loan is expected to be lower when it switches to P&I but this effect is more than offset by the principal repayments.

Dr Kent said analysis of loans that have already triggered shows that "some fraction" of interest-only borrowers may have used the interest-only period to spend more than they otherwise would - failing, in effect, to build up reserves for the higher repayments post-reset.

"However, the available data, and our liaison with the banks, suggest that there are only a small minority of borrowers who will need to reduce their expenditure to service their loans when their interest-only periods expire."

RBA to monitor reset closely

In a potential flag for the current banking royal commission, Dr Kent noted that the Australian Securities and Investment Commission has forced eight banks and lenders to provide "remediation to borrowers that face financial stress as a direct result of poor lending practices related to interest-only lending.

More than 0.2% per cent on average per annum over each of the next three years.

"As yet, however, only a small number of borrowers have been identified as being eligible for such remediation action," Dr Kent noted in a footnote to his speech.

Dr Kent said the Reserve Bank would continue to monitor the interest-only loan reset "closely", and said that the regulatory crackdowns in 2015 and 2017 on such loans were warranted.

"The tightening in standards starting in 2014 has helped to ensure that borrowers are generally well placed to service their loans.

"And the limit on new interest-only lending more recently has prompted a reduction in the use of those loans during a time of relatively robust growth of employment and still very low interest rates.

"In this way, it has helped to lessen the risk of a larger adjustment later on in what could be less favourable circumstances."

Over the past year, the stock of interest-only loans has fallen by around $75 billion, out of a total stock of almost $600 million in late 2016.

"While many of the customers switching chose to do so in response to the higher rates on interest-only loans, there are likely to have been some borrowers who had less choice in the matter," he said.

"Some borrowers may have preferred to extend their interest-only periods but may not have qualified in light of the tighter lending standards.

"We don't have a good sense of the split between those borrowers that switched voluntarily and those that switched reluctantly.

"However, our liaison with the banks suggests that most borrowers have managed the transition reasonably well. Also, the share of non-performing housing loans over the past year remains little changed at relatively low levels.

"Moreover, the growth of household consumption has been sustained; indeed it picked up a touch in year ended-terms over 2017."