Australia’s version of the sub-prime crisis that ushered in the global financial crisis could be looming, with a significant number of the 1.5 million households with interest-only loans likely to struggle with higher repayments, experts warn.
Martin North, the principal at consultancy Digital Finance Analytics, said interest-only loans account for about $700 billion of the $1.7 trillion in Australian mortgage lending and it was “our version of the GFC”.
“My view is we’re in somewhat similar territory to where the US was in 2006 before the GFC,” Mr North said.
Craig Morgan, managing director of Independent Mortgage Planners, said one in five people who took a loan two or three years ago would not qualify for the same loan now, because of the crackdown on lending by the regulator and ongoing fallout from the Royal Commission into financial services.
“In the last six months lenders have had this lightbulb moment of what ‘responsible lending’ means,” Mr Morgan said.
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One of the triggers for the GFC was rising defaults from over-leveraged borrowers who were unable to refinance when their honeymoon rates ended. However, the sub-prime lending in the United States before the GFC included large mortgages being given to people without jobs or on minimum wage.
“This is absolutely not ‘sub-prime’ in the US definition but there were people [in Australia] who were being encouraged to get very big loans on the fact that principal & interest was impossible to service but they could service interest-only,” Mr North said.
“We also know that some interest-only loans were not investors but they are actually first-home buyers encouraged to go in at the top of the market.”
The Reserve Bank has previously warned $500 billion in interest-only loans are set to expire in the next four years, causing a significant jump in repayments of 30-40 per cent when borrowers are forced to start paying back the principal.
The banks pushed interest-only home loans – where the borrower pays interest but never reduces the loan balance - over the past five years, because they enabled people to borrow bigger amounts. They were favoured by investors who could claim the interest as a tax deduction and were often looking to pay the minimum in order to cross-leverage and buy multiple properties.
The typical structure of a such a loan has interest-only repayments for five or sometimes 10 years, at which point it reverts to being principal & interest with repayments 30-40 per cent higher. The lending criteria has tightened in the past six months to a year, so many borrowers would be unable to refinance to another interest-only loan.
Mr Morgan warned the jump in repayments could be higher than the 30-40 per cent forecast by the Reserve Bank, because many people would not qualify for a new 25 or 30-year loan and would be forced to repay the principal over a shorter period.
Mr North dismissed this risk. “Most banks are willing to lend up to the full term as if it were a new loan,” he said.
His modelling suggested $120 billion of interest-only loans would fail tighter lending criteria over the next three years; about two in three of those loans would be able to accommodate a switch to paying the principal, while one in three would be forced to sell.
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Mr North said a lot of households were “struggling a little bit” because wages were flat and costs were going up. “It’s enough to give a bit of a shock to the banking system here and to put a number of households under pressure,” he said.
RBA assistant governor Christopher Kent said in April the bank’s data suggested many borrowers would have savings to help them meet the higher payments, and others would be able to refinance their loans. He said only a "small minority" of customers would have trouble when their interest-only term expired.
James Keillor, a senior credit consultant at Oxygen Home Loans, said tighter lending standards meant it was “difficult if not impossible” to refinance if you had borrowed at your maximum in recent years but he was optimistic about the capacity of borrowers to absorb the higher costs.
He pointed out lenders had assessed borrowers’ capacity based on principal & interest at current interest rates plus 1-2 per cent and added that the current low interest rates had allowed many homeowners to build a buffer.
“Most borrowers in my experience generally pay more than the minimum, or utilise an offset facility to build cash reserves,” Mr Keillor said. “Most will adapt reasonably well as they are already making repayments in excess of the minimum.”