A leading financial services expert has described the rise in interest-only mortgages among first home buyers as “disturbing” and likely to trigger higher loan defaults in the future.

Data published by the Australian Prudential Regulation Authority shows that more first home buyers are resorting to interest-only loans to get a foothold in the property market.

The official statistics show that the total value of interest-only loans made by Australian banks rose by $10 billion to $481 billion in the June quarter.

Historically, interest-only loans have been popular among investment borrowers, but the latest data shows that owner-occupiers now account for a larger proportion of interest-only mortgages compared to June 2015.

Dr Adrian Raftery, a senior lecturer in financial planning at Deakin University, believes the trend in the official data indicates that a time bomb might be ticking for thousands of low-income borrowers who bought into the booming property market in the last 12 months.

“There’s been a lot of brainwashing from the operators of get-rich-quick schemes encouraging investors and owner occupiers to take out interest-only loans,” Dr Raftery told The New Daily.

“Brokers are also contributing to the growth of interest-only mortgages because they get bigger trail commissions from banks when borrowers take longer to reduce the principal.

“This is a disturbing trend.”

The problem with interest-only loans is that borrowers do not build equity in their homes until their mortgage contract requires them to start reducing the principal.

That can be up to 10 years after they take out the loan.

“If there is an economic downturn and interest-only borrowers lose their jobs they have little room to adjust their repayments with the bank,” Dr Raftery said.

“For people with few assets or savings that might force them to sell the mortgaged property at a loss.

“Australia could lose a whole generation of savings because of how these loans are structured.” 

Interest-only loans are ‘irrational’ for first home buyers on low incomes 

At the end of June this year the value of interest-only loans in Australia exceeded the value of investment loans by $60 billion.

That means the banks are now selling a larger number of interest-only mortgages to owner-occupiers.

This was not meant to happen because bank regulators have been trying to crack down on the growth of risky lending practices in the banking system since the middle of last year.

Interest-only loans add to credit risk in the banking system because they take much longer for borrowers to pay off.

Dr Raftery is concerned that banks are contributing to the build-up of credit risk in Australia by writing more interest-only loans, especially to people on low incomes.

“If you’re buying a house to live in, interest-only loans are not a rational way to go for first home buyers,” he said.

“If there is a correction in the property market or a downturn in the economy a lot of people are going to default on these loans.

“Owner-occupiers should be using the current low interest rate environment to pay down as much of the loan principal as they can.” 

ASIC preparing to release findings of probe into mortgage market

A report published last year by the Australian Securities and Investments Commission found that mortgage brokers were mostly responsible for the rise in interest-only lending.

The rise in the number of owner-occupiers taking up interest-only loans could force ASIC’s hand and lead to a clampdown on the professional conduct of brokers.

ASIC is continuing to investigate whether trail commissions paid by the banks to brokers should be abolished because they have the potential to distort product recommendations made to borrowers.

Trail commissions are paid annually to brokers for recommending a lender’s credit products to borrowers and are calculated as a percentage of the loan balance.

Because it takes many more years for interest-only borrowers to retire debt, brokers receive more trail income from interest-only mortgages than they get from standard home loans. 

Tips for new home buyers looking for a loan 

Mortgage experts are cautioning prospective owner-occupiers against interest-only loans because they are likely to inflate the total cost of buying a home.

Kirsty Lamont, a director of financial services research house Mozo, recommends that borrowers consider the extra risks of not reducing the loan principal in the early years of a mortgage contract.

“Using an interest-only loan to buy a dream home is akin to buying something on a credit card – if you don’t understand the risks it could cost you more,” said Ms Lamont. 

Mozo’s tips for borrowers contemplating an interest-only loan:

• If you earn low income and have few assets, you are essentially gambling that your home will increase in value.
• Question why your broker is recommending an interest-only loan. Is it because you do not meet the criteria for a standard mortgage?
• Is it because the broker stands to collect more commission dollars for introducing you to a lender?
• If you find selecting the right mortgage difficult then seek advice from an independent financial adviser before signing up to an interest-only loan.
• Understand that you are in a better position to amend the repayments on your home loan if you have paid off more than half of the principal. This might be important if you lose your job during an economic downturn.

Original article posted here on The New Daily on 12 October 2016