IO loans “key tail risk” in market

One research firm has flagged interest only loans as presenting potential risks for both borrower defaults and bank profits

IO loans “key tail risk” in market



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

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