An increase in the number of Australian “owner-occupier” home buyers who are taking out interest-only (IO) mortgages is credit negative for future Australian Residential Mortgage Backed Securities (RMBS) because such loans have a higher risk of delinquency and default, particularly if interest rates rise from their current record low levels.
Over the past year, a notable rise has occurred in the amount of IO loans in Australia and owner-occupiers – people who buy a home to live in, as opposed to investors who buy to rent out — are accounting for a growing share of these loans.
IO loans are common among real estate investors in Australia because interest costs on investment loans can be claimed as a tax deduction.1 However, owner-occupiers cannot claim such deductions. There are concerns that many of the owner-occupiers taking out these loans — which are generally larger than the traditional Principal and Interest (PI) loans — would consequently find it difficult to service them if interest rates start to rise.
Greater Delinquency Risk as Owner-Occupier Interest Only Loans Grow
IO loans accounted for 43.2% of all new mortgages in June 2014, up from 38.6% in June 2013, according to the latest Australian Prudential Regulation Authority figures. Over the same period, the proportion of loans for investment properties also rose — to 37.9%, from 35.2% — but not by as much as the rise in IO loans.
The growing gap between the percentage of IO loans and investment loans, as seen in Exhibit 1, shows that more owner-occupier borrowers are taking out IO loans.
IO loans, whether they are for owner-occupiers or real estate investors, generally carry a greater risk of delinquencies and default than traditional PI loans.
In particular, IO loans are more sensitive to interest rate rises than PI loans because of their larger amounts and slower amortization rates. IO loans are most sensitive to higher interest rates when they revert to PI loans — which typically occurs after 5-10 years — and monthly repayment amounts rise significantly.
If the proportion of owner-occupier IO loans continues to rise, we would expect that they would also make up a greater proportion of the loans in future RMBS transactions, which would be credit negative, given their higher propensity for delinquency and default.
Owner-occupier IO loans account for 16.5% of the current RMBS portfolio, but these do not present the same risk as new owner-occupier IO loans because they were underwritten when interest rates were higher and would be more resilient when rates rise again.
In the current record low interest rate environment in Australia, delinquency rates for IO loans have in fact been lower than for PI loans (Exhibit 2). This situation reflects the fact that monthly repayments for IO loans are lower than PI loans. However, our expectation is that interest rates in Australia will rise in 2015, putting more pressure on IO borrowers and resulting in greater levels of delinquencies and defaults.
Real estate investors in Australia can claim a tax deduction for the interest costs of their loans, which will help offset the impact of higher rates. However, owner-occupiers are not eligible for such deductions. For this reason, all else being equal, an increase in interest rates will be more severe for owner-occupier IO borrowers than investment borrowers.
Owner-Occupiers Turn to IO Loans as Property Prices Increase
At a time when property prices and therefore the size of mortgages in Australia is rising rapidly, the increase in the number of owner occupiers taking out IO loans may reflect their decision to take out larger loans amounts, given the rise in property prices.
In Australia, national house prices have increased by 9.3% over the year ended September 2014, while in Sydney, the city with the highest growth, prices have risen by 14.3%.5
Against this backdrop, home buyers may view IO loans as an option if they seek to borrow larger amounts without having to service as large a monthly repayment amount as they would have to with a similarly sized PI loan.
In our existing RMBS portfolio, the average loan size of owner-occupier IO loans is AUD289,800, compared with AUD187,500 for PI loans.
In addition, the current loan-to-value ratio of owner-occupier IO loans is 2.1% higher than PI loans. IO loans are also paid off at a slower rate, as reflected by the fact that they are 5.1% in advance of their scheduled payment balance, compared with 6.5% for PI loans.7 Hence, owner occupier IO loans are larger, more leveraged and slower to amortize than PI loans.
Accordingly, once interest rates rise from their current record low levels, any issues owner-occupier IO loan borrowers have with servicing their mortgages will be exacerbated, leading to higher delinquencies and defaults.
However, it is also important to note that some owner-occupier borrowers may be choosing IO loans simply to maintain a level of flexibility in managing their repayment obligations, rather than because of serviceability reasons.8 Given that interest rates are at record lows, these borrowers may feel comfortable in paying only the interest on their mortgages and using any remaining available funds for other purposes.
But, because these borrowers are making few, if any, principal repayments, their loan amounts will remain high relative to PI loans, leaving them more susceptible to payment shocks when interest rates rise.
What a bunch of fools, the stupidity of Australians is truly staggering!
After a bubble has burst, no one denies that it existed. But before it does, the popular refrain is that though bubbles existed elsewhere in the world, “there’s no bubble here”. So housing bubbles are admitted to have existed in Japan, the USA, Spain and Ireland – because they’ve already burst.
A unifying narrative is required to adequately describe how so many countries allowed their housing systems to be captured by the interests of banks and wealthy elites.
Look at Sweden and Norway for example. Absolute madness.
There is a terrific book waiting to be written on this period of history.
And when i see the useful idiots here cheering the whole racket on, well....
Property acquisition as a topic was almost a national obsession. You couldn't even call it speculation as the buyers all presumed the price of property could only go up. That’s why we use the word obsession. Ordinary people were buying properties for their young children who had not even left school assuming they would not be able to afford property of their own when they left college- Klaus Regling on Ireland. Sound familiar?
The evidence of nearly 40 cycles in house prices for 17 OECD economies since 1970 shows that real house prices typically give up about 70 per cent of their rise in the subsequent fall, and that these falls occur slowly. Morgan Kelly:On the Likely Extent of Falls in Irish House Prices, 2007
I think it is perhaps time to pause and contemplate the benefits of an interest-only home loan.
If you’re searching for an investment property, or looking for a short-term solution offering lower repayments, you may want to investigate taking out an interest-only home loan.
As its name suggests, an interest-only loan is precisely that: one makes interest payments but doesn't pay back any of the principal loan amount owing.
At the conclusion of the interest-free period (this is perhaps one to five years) the borrower is then required to start making principal and interest repayments (so it's prudent, I think, to make sure your future finances can support this).
If you buy low and sell high, and keep your renovation costs to a minimum then this is an advantageous way to get financially ahead. Interest-only loans were originally designed for those buying an investment property. Because you’re only paying the interest component your monthly repayments will be lower. This gives you greater control over your cash flow, freeing up funds for other investments. There are also potential tax and negative gearing benefits.
Some of the property investors I've spoken with who specifically buy to build will take out interest-only home loans for a short term period then pay back the principal when they sell the renovated property for a profit. The risk and the hope is that that the property sale price will cover the principal loan amount, the interest-only repayments and the construction costs.
Given the underlying strengths of the economy, about the biggest mistake we could make would be to talk ourselves into unnecessary economic weakness.
At the conclusion of the interest-free period (this is perhaps one to five years) the borrower is then required to start making principal and interest repayments (so it's prudent, I think, to make sure your future finances can support this).
The cracks in your knowledge are beginning to show Glenn.
Yes the initial I/O period is up to 5 years, but for an investor that can be reset twice again up to a max of 15 years with the loan then amortised over the remaining term, which would be another 15 years for younger buyers.
For a PPOR home buyer the max I/O period is 10 years with the loan then amortised over the remaining 20 years. Of course any reset is at the banks discretion, and they may not agree if the loan conduct hasn't been acceptable.
I see that you are now giving tips on buying shares. You are a man of many talents.
Any expressed market opinion is my own and is not to be taken as financial advice
The cracks in your knowledge are beginning to show Glenn.
Yes the initial I/O period is up to 5 years, but for an investor that can be reset twice again up to a max of 15 years with the loan then amortised over the remaining term, which would be another 15 years for younger buyers.
For a PPOR home buyer the max I/O period is 10 years with the loan then amortised over the remaining 20 years. Of course any reset is at the banks discretion, and they may not agree if the loan conduct hasn't been acceptable.
I see that you are now giving tips on buying shares. You are a man of many talents.
Peter If 10 years for PPOR, when do the first waves of resets happen based on when I/O loans became popular?
Peter If 10 years for PPOR, when do the first waves of resets happen based on when I/O loans became popular?
It's been this way for a long time, there is no wave of resets due. It's pretty unlikely that home owners would choose to go 10 years on interest only. I only ever set I/O for the first 2 years for PPOR buyers. The difference between repayments for a loan over 30 years and 28 years is SFA.
Our products are quite different to those elsewhere, that's why overseas commentators keep falling into the same trap, as you also do.
The irony is that in your area you could have picked up an absolute bargain, but you let that opportunity pass you by because you believed the crap that you read.
Any expressed market opinion is my own and is not to be taken as financial advice
It's been this way for a long time, there is no wave of resets due. It's pretty unlikely that home owners would choose to go 10 years on interest only. I only ever set I/O for the first 2 years for PPOR buyers. The difference between repayments for a loan over 30 years and 28 years is SFA.
Our products are quite different to those elsewhere, that's why overseas commentators keep falling into the same trap, as you also do.
The irony is that in your area you could have picked up an absolute bargain, but you let that opportunity pass you by because you believed the crap that you read.
Peter I asked the question and you answered. Thanks. No waves of resets in OZ, got it. I have not heard much about I/O resets in OZ from any commentators, thus I asked you. I am not looking for a resendential property in my area, however if I was I think they still have more house price deflation to come.
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