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for Interest-only loans

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 years.

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 regulators.

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.

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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 suitable.

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 term.

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 property sooner.

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 period; and
  • 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) [2014] FCA 946 & (No 2) [2015] 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 leave.

Implications for Lenders in Australia

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 years.

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 Lexology which is an international innovative, web-based service that provides over 200,000 company law departments and law firms around the world with a depth of free practical know-how on specialist areas of law © Copyright 2015 Sydney

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