IO loans “key tail risk” in market

by Miklos Bolza13 Oct 2017
Interest-only loans represent a key risk to both banks and borrowers through interest rate repricing, loan switching and mortgagee characteristics, according to one global research agency.

This combination may cause higher levels of loan defaults and decreased profits for lenders, said analysts from Morgan Stanley Research in a new paper entitled Crunch Time: Switch and Thrift which surveyed over 1,800 mortgage holders.

With rates on interest only loans around 50 basis points higher than the equivalent principal and interest products, borrowers were more likely to switch and lower their costs of borrowing which could create a headwind for bank margins.

The report estimates that the margins of the major banks would be lowered by around two basis points per year if 25% of interest-only borrowers made the switch. The survey found that around 60% of interest-only loan customers would consider changing to a principal and interest loan if rates rose by 75 basis points.

Borrowers with IO loans also represent a “key tail risk” in the housing market, the report said, citing that borrowers with these types of loans:
  1. Had fewer savings despite referring principal payments
  2. Were three times more likely to sell their property than P&I borrowers if rates rise
  3. Were more likely to have increased debt burdens after only purchasing their properties in the past five years
Young people were more adverse to potential impacts, the researchers said, as they were more likely to have an interest-only loan. They were also more likely to have only purchased their home recently and have used up more of their credit limits.

“Given that [IO loan] rates have increased by more than P+I rates, we believe younger people will be more impacted by higher interest rates.”

In all, increased rates for investor and interest-only mortgages reduced disposable income by 20 basis points in the first half of 2017, analysts said. Further changes in the second half of this year are expected to lower this by a further 17 basis points.

At the same time, household incomes for borrowers switching from IO to P&I were hit by a three basis point reduction in 1H17. A further six basis point reduction is expected in 2H17.

“Taking into account the additional repricing in June/July, and assuming current leverage and switching trends continue, we expect a similar reduction in disposable income in the second half of the year,” the analysts said.

“These changes are the equivalent of ~50bp in RBA cash rate hikes, given that the changes are a hit to borrowers, without a compensating offset into savers' deposit rates.”

Related stories:

No maths formula for rate repricing: Westpac

ASIC releases its review of interest-only home loans

Mortgage holders struggling under rate hikes

COMMENTS

  • by P.Doff 13/10/2017 9:01:53 AM

    BLAH BLAH BLAH BLAH BLAH BLAH INTEREST ONLY BLAH BLAH BALA

  • by Bottom Line 13/10/2017 9:56:55 AM

    With all due respect...seems to be a lot of statistical external experts who don't actually write loans or work directly with the public (and hence cant interpret data correctly); that seem to now tell us - daily - that the things that have worked for 60 years, are suddenly all going to stop working. eg interest only has been around for decades, yet suddenly overnight they became bad. We went through 2007 with interest only loans, and we survived better than any other country. Now suddenly they are considered a disaster.....the country and finance sector worked well before we had ïll informed "external ëxperts"....and when we had non-invasive government......these groups are the biggest risk to crashing the system/market.

  • by N Spacecadet 16/10/2017 10:09:59 AM

    Next a mortgage broker will be responsible for everyone spending habits... Who are we to tell a person not to go to the pub and have a Parma as it may affect their interest only loan repayment. Sorry you cant buy your smashed Avo at the local Cafe as Interest only payments are the evil enemy and you wont be able to afford P&I repayments. Sorry you cant go down the peninsula and spend some time with your family over the holidays as it could change your living expenses and your ability to make a loan repayment. consumer needs to take responsibility for their actions as well.. We cannot control everything! We can only go off what the customer tells us - we cannot look into the future, and all loan submissions, verification, assessments are based on historical data. The Banks build in buffers for I/O repayments and other debts and that is fair and reasonable.
    Interestingly while this person has had their interest only investment loan - their wealth has grown in some circumstances by hundreds of thousands of dollars. Tell me what i have done wrong by these people?
    The regulators might want to look into how easy it was for these people to be placed into a car lease or a credit card limit increase while having these loans - all of which put more pressure on the ability to make repayments.
    Instead of slamming brokers - how about congratulating them for the benefit they provide these consumers by giving competition and choice.