- APRA, Australia’s banking regulator, has been tightening lending standards in recent years, including the introduction of a 30% limit on interest-only lending as a proportion of new mortgage debt.
- This has contributed to recent declines in Australian home prices, especially in Sydney and Melbourne.
- Morgan Stanley continues to warn that by forcing some borrowers to switch to principal and interest repayments, it risks “feeding the consumer cash flow and credit crunch”.
APRA’s push to curb interest-only mortgage lending has already left its mark on Australia’s property market.
Home prices are falling, especially in Sydney and Melbourne — markets previously favoured by investors. The dollar value of home loan lending is also starting to weaken as is housing credit growth, reflecting not only tighter lending standards but also a continued switch away from interest-only to amortising mortgage repayments.
Other housing market indicators such as auction clearance rates and new home sales have also weakened noticeably, raising concerns about what the housing market slowdown could do to household spending levels, especially at a time when wage growth remains soft and hiring levels are starting to slow.
Morgan Stanley’s Australian equities team is nervous about what may lie ahead.
However, in contrast to concerns raised by some about the possible negative wealth effect caused by falling home prices, it’s wary about what the continued switch to principal and interest mortgage repayments could do to disposable income levels, warning it could add to the consumer cash flow and credit crunch already impacting many households.
“The step up in repayments on interest-only (IO) to a principal and interest mortgage conversion is well known,” the bank says.
“However, what is more concerning is that monthly repayments as a percentage of disposable income could rise by about 10 percentage points (ppts) for those servicing loans with a debt-to-income ratio (DTI) of four times, or about 15ppts for those with loans of six times DTI.”
The bank estimates that for customers with mortgages six times income, repayments could then be consuming about 60% of their disposable income versus around 40% for those with mortgages four times income upon conversion based off a 25-year repayment term.
“We think the consumer is facing a cash flow and credit crunch given weak income growth, ‘cost of living’ inflation, tighter credit conditions and IO switching, which will put pressure on discretionary spending and household savings,” Morgan Stanley says.
While not all borrowers will be forced to switch to principal and interest repayments given APRA’s regulatory changes still allows for a maximum of 30% of new lending to be interest-only mortgages, the potential risks have not been lost on the Reserve Bank of Australia (RBA).
In a speech delivered earlier this year, Christopher Kent, Assistant Governor at the RBA, said an interest-only borrower with a $400,000 30-year mortgage with a five-year interest-only period could see required payments increase by around 30–40% if moved to an amortising repayment schedule.
“The rise in scheduled payments amounts to about $7,000 per year for the representative interest-only borrower,” Kent said. “This is a non-trivial sum for the household concerned.”
The RBA estimates that about $120 billion of interest-only loans are scheduled to mature each year until 2020.
Despite that hit to disposable incomes that will be felt by some borrowers, from a broader perspective, Kent said the impact on Australia’s household sector is likely to be “moderate” with the effect on household consumption “likely to be even less”.
“This is because some interest-only borrowers will be willing and able to refinance their loans,” Kent said.
“Also, many others have built up a sufficient pool of savings, or will be able to redirect their current flow of savings to meet the payments, or have planned for, and will manage, this change in other ways.”
Kent described the transition away from interest-only loans over the past year as “relatively smooth overall”, adding that it is “likely to remain so”.
“Nevertheless, it is something that we will continue to monitor closely,” he said.
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