This housing expert thinks Australian investors may be heading towards the 'cliff edge' on loan repayments

Photo: Dean Treml/Red Bull via Getty Images.

Recent restrictions on interest-only lending have increased concerns around Australian housing stability, if investors are forced to start paying down principal in addition to the interest on their loan.

In a note titled “Cliff edge”, housing expert Pete Wargent said those stricter lending standards have led to speculation an increasing number of borrowers could topple over a “principal and interest cliff” when their interest-only loan expires and they’re unable to roll it over.

Most interest-only loans have a five-year term, at which point it’s rolled over or converts to principal & interest repayments.

“The repayments might be up to 40% or more higher when the principal payments kick in, so household cashflows need to be carefully managed,” Wargent said.

Interest-only lending peaked in 2015 before APRA’s first round of macro-prudential restrictions. In view of that, Wargent expects the highest number of interest-only loan terms will be due to roll over in 2020.

This chart shows Wargent’s estimate of the dollar value of interest-only loans for which borrowers will be forced to convert to principal & interest repayments:

Source: Pete Wargent Daily Blog

As part of macro-prudential measures introduced in March to try and curb property market speculation, APRA put a cap on interest-only lending at 30% of all new loans.

Australian banks also offered no-cost switches into principal & interest repayment plans, and enforced stricter loan to value (LVR) requirements for interest-only borrowers.

Based on those changes, “it’s possible to make a rough assessment or estimate of the value of IO loans falling due approved under conditions that would likely fail today’s underwriting standards”, Wargent said.

The estimates suggest that around $40-55 billion in interest-only loans will come up for renewal between 2018 and 2020.

“By 2016, the share of new interest-only loans in the market had been pared back, and therefore the P&I cliff will also begin to taper off by 2021,” he added.

This chart from Citi provides a good measures of how rampant interest-only lending was in 2015, to borrowers now facing revised loan-terms in 2020.

In the March quarter of 2015, interest-only lending made up almost half of new loan flow:

In a research report released this morning, Citi also calculated that the total value of interest-only loans in Australia currently amounts to approximately $643 billion.

The bulk of interest-only loans are taken up by investment professional for tax benefits. However, Citi also reported a sharp rise in interest only loans taken out between 2011 and 2017 by the “suburban mainstream” — middle income workers and younger families.

Based on those figures, if income growth remains low a number of Australian households could be facing increased pressure from a sharp rise in mortgage costs over the next three years as interest-only loan terms expire.

Wargent expects the changes to suck some “hot air” out of Australia’s property market. “I don’t know if it’s a doomsday scenario, but it will most likely make property less attractive as an asset class”, he told Business Insider.

“In the wash-up, one can’t help but feel that investors that opted for quantity over quality of investment properties might be left staring down the barrel of some unenviable decisions.”

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