PROPERTY LOAN ALERT
Currently, over 40% of new loans in Australia are
interest-only (I/O) for the first few years before reverting
to principal and interest (P & I) for the remainder of the
term. A typical loan is I/O for 5 years, then P & I for 25
Interest-only loans are popular because they conserve the
cash flow needed to make the repayments, freeing up funds
for more property investment. That is a fine strategy, until
the interest-free period comes to an end and the repayments
increase by 50%!
At that point, unless the property yield (for investors)
or salary (for owner-occupiers) has increased by 50%, the
borrower must reach into their pocket to make the increased
repayments. The prospect of borrowers defaulting on the loan
at that point has been worrying the Australian financial
As a result, they have required lenders to tighten their
credit policies so that interest-only loans are becoming
harder to obtain, by assessing a borrower's ability to repay
on the increased P & I payments, as opposed to using the I/O
payments which they have used up to this time.
For more information
Why interest-only loans are
being restricted in Australia
Australian lenders are tightening credit policies for
interest-only loans for investors and owners to buy properties.
Westpac CEO Brian Hartzer has noted that In the UK,
interest-only loans are now only a fully advised financial
product. He explained that A fully advised product means
that you are able to demonstrate the customer’s ability to
pay, that you have evidence of that, and that the product is
Interest-only loans are popular for property investors
and owners in Australia – they represent 37.4% of all
residential term loans held by the Australian Banking
System. That percentage is increasing - in the March quarter
it was 42.3% of loans.
In Australia, the financial regulators have identified
interest-only loans for residential properties as higher
risk loans and have tightened the responsible lending
guidelines for loan assessments.
This article is an overview of the new regulatory
requirements for interest-only loans.
The UK Financial Conduct
Authority (FCA) Guidance
In the UK, interest-only loans are often 25 years, hence
the term ‘lifetime mortgage’.
As Brian Hartzer has noted, in the UK the FCA has issued
guidance to lenders entitled Dealing fairly with
interest-only mortgage customers who risk being unable to
repay their loan to enhance lending standards.
Lenders need to consider what options can be offered to
interest-only customers so as to act fairly to ‘trapped’
customers, who are unable to exit the mortgage at the end of
The FCA gives examples of options being - to either
extend the term or to switch to a full or part
capital-repayment basis, or a combination of the two.
The Australian Prudential
Regulation Authority (APRA) focus on sound lending practices
APRA is taking steps to reinforce sound mortgage lending
practices by the Banking Sector, with higher risk mortgage
lending a particular concern.
APRA’s aim is to discourage higher risk mortgage lending
for property investors, so as to help keep bank loan
portfolio growth to 10% pa.
APRA identifies these loans as higher risk mortgage
lending: interest-only loans to owner occupiers, high
loan-to-income loans, high loan-to-valuation (LVR) loans and
loans with very long loan terms.
APRA defines an interest-only loan as: A loan in which
only interest is paid during the loan term. The loan may
revert to principal and interest repayments at the end of
the loan term. The interest-only term is usually for a
period of one to five years, although it may extend longer.
The Australian Securities
& Investments Commission (ASIC) focus on responsible lending
ASIC administers the National Credit Act. It applies to
all lenders and mortgage brokers in Australia.
Promoters of interest-only loans point to freeing up cash
flows because of lower repayments, interest being tax
deductable on investment loans, and the ability to buy
ASIC is concerned about the risks that borrowers face
with interest-only loans, such as:
- Whether the borrower can only afford a loan because
it is interest-only
- Whether the borrower can afford principal and
interest payments at the end of the interest-only
- Whether the borrower understands the impact of not
making principal and interest repayments
In decision of Australian Securities and Investments
Commission v The Cash Store Pty Ltd (in liquidation)
 FCA 946 & (No 2)  FCA 93, Justice Davies of the
Federal Court of Australia reviewed whether the loans made
by the Cash Store were unsuitable. He said:
The Credit Act provides that the credit licensee must
assess the credit contract as “unsuitable” if it is likely
that the consumer would not be able to repay the loan
without substantial hardship or if the contract would not
meet the consumer’s requirements or objectives.
Justice Davies found that the Cash Store was in breach of
the Credit Act because it failed to make reasonable
enquiries about the financial situation, requirements and
objectives of its customers. As a result, the Cash Store was
ordered to pay the maximum pecuniary penalties of $1,100,000
per contravention, a total of $11,825,000.
In its Regulatory Guide 209 Credit licensing:
Responsible lending conduct (RG 209), ASIC gives
this example which illustrates the need to assess the
borrower’s capacity to repay a loan without substantial
hardship where a lump sum is payable at the end of the term.
Example 14 asks whether a loan where a large
‘balloon’ payment is payable at the end is suitable in terms
of exit strategy. ASIC says that the credit licensee must
satisfy itself that the consumer understands and has the
capacity to cover the final lump sum payment before offering
this product to the consumer.
ASIC has updated RG 209 following the Cash Store
decision, with a new example where an interest-only loan may
meet a consumer’s initial requirements and objectives, which
reverts to principal and interest later on.
Example 19 looks at whether the loan product is
suitable in terms of affordability. It looks at a young
couple who apply for an interest-only loan to purchase a
residential property. ASIC says that the mortgage broker
must make reasonable enquiries about why the loan is to be
interest-only, and says that an interest-only loan would be
satisfactory for a short period of time if the broker
verified their explanation that their income would increase
due to the partner returning to work following maternity
Implications for Lenders in
The financial regulators in Australia are looking
carefully at interest-only loans.
In Australia, a typical interest-only loan is a 30-year
loan which is interest-only for the first 5 years. It
reverts to principal and interest for the remaining 25
A credit assessment is carried out at the start to ensure
that the loan is not ‘unsuitable’ by requiring reasonable
enquiries about the customer’s ability to repay. In the
light of the Cash Store decision, responsible lending
practice appears to require that borrowers be assessed on
their ability to repay the principal and interest payments
during the “residual” period of the loan.
Because loan repayments increase by almost 50% when an
interest-only loan reverts to a 25 year principal and
interest loan, this approach will significantly reduce the
borrower’s capacity to borrow.
For these reasons, it is inevitable that interest-only
loans will decline as a loan product in Australia.
This article was first published by Cordato Partners in
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