Sub-prime mushrooms as FHBs go interest-only

Got to keep that ponzi going! From The New Daily:

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.” 

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 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.” 

From Wikipedia on the US housing bust:

The United States (U.S.) subprime mortgage crisis was a nationwide banking emergency that contributed to the U.S. recession of December 2007 – June 2009.[1] It was triggered by a large decline in home prices after the collapse of a housing bubble, leading to mortgage delinquencies and foreclosures and the devaluation of housing-related securities. Declines in residential investment preceded the recession and were followed by reductions in household spending and then business investment. Spending reductions were more significant in areas with a combination of high household debt and larger housing price declines.[2]

The expansion of household debt was financed with mortgage-backed securities (MBS) and collateralized debt obligations (CDO), which initially offered attractive rates of return due to the higher interest rates on the mortgages; however, the lower credit quality ultimately caused massive defaults.[3] While elements of the crisis first became more visible during 2007, several major financial institutions collapsed in September 2008, with significant disruption in the flow of credit to businesses and consumers and the onset of a severe global recession.[4]

There were many causes of the crisis, with commentators assigning different levels of blame to financial institutions, regulators, credit agencies, government housing policies, and consumers, among others.[5] A proximate cause was the rise in subprime lending. The percentage of lower-quality subprime mortgages originated during a given year rose from the historical 8% or lower range to approximately 20% from 2004 to 2006, with much higher ratios in some parts of the U.S.[6][7] A high percentage of these subprime mortgages, over 80% in 2006 for example, were adjustable-rate mortgages.

Interest-only loans are a form adjustable-rate mortgage. Pure sub-prime stuff.

Comments

  1. If interest only loans were outlawed, prop prices would fall by 20%.
    As people are only buying based on “being able to fund”, not pay back

    • What would the price drop be if negative gearing and the capital gains discount was removed at the same time?
      As long as housing is a tax break and a gambling chip the nation will suffer

      • About 0.5%pa reduction in growth according to the McKell Institute (that’s with CGT discount being halved, not scrapped entirely).

        So no actual fall.

      • hahahahha we will be lucky Athas if that ends up being what happens
        I’m expecting via the revert to mean forces at play over the long term expressed as price/disposable income to overshoot on its revision, that means a 75% fall over time
        bring it on

      • Interest normalisation wont happen for at least ten years.
        The debt levels are massive and if I recall correctly, there was a stat that said something like 25% of mortgagee’s would default under four .25% interest rate rises – a lousy 1%

    • “If interest only loans were outlawed, prop prices would fall by 20%.”

      Interest only loans are a legitimate tax planning tool, and this isn’t the problem.

      – Negative Gearing
      – 50% CGT discount after a mere 12 months
      – Structurally low rates
      – Lax foreign buying laws, and a seeming desire to turn Melbourne and Sydney into Tier 1 real estate destinations like London and NY for cashed up foreigners

      The above is the real issue, not an interest only loan.

  2. In light of the lessons of the GFC, what I’m reading here beggars belief. A property crash is likely to take EVERYTHING with it. We are now vulnerable to an external shock. Has anyone noticed how the credit collection businesses on the ASX are having a good run. Interesting.

    • There’s really not much left but government, fraud, bubbles, and services in our ekonomee.

      The CPI print was laughable. The only things inflating (ignoring houses of course because that’s not inflation) are largely government controlled. Sin, health, education. Everything else is sliding like a cat on a slipperydip. Trying to get its claws into the corroded edges.

  3. casewithscience

    People need places to live and houses are not investments. This behaviour should not be a mystery at all.

    • We need power and water. These things are regulated.

      Houses…. not so much.

      Or perhaps regulated in the wrong way – as some argue supply is constrained.

    • “toehold in the property market” all of our media is just a bullshit mind control operation! Pathetic

      • I used to rock climb. The thing about a toe hold, is it is fucking useless without at least one good hand hold.

      • For most first home buyers the toe hold is 20m above the ground, the nearest thing to grab hold of is another 10m up, and they are dangling upside down.

    • Fair value is only one state of many… There will be under valued states and over valued states as well at different times for different lengths of times.

    • I wouldn’t be so pleased

      You and your children as taxpayers and citizens will end up owning these nonperforming mortgages when the government buys them from the banks

      • That’s a possibility. But at the same time happy to take my chances vs certainty of the current hell on 1st world Earth. My preference is for those who don’t pay their debts to be an “asset” on the banks balance sheet for their entire lifetime, regardless of bankruptcy rulings, until they repay their obligation. The law needs to improve accordingly, hopefully the banks push this through soon in preparation.

      • Exactly!

        Have a big fat cash deposit? No, you’ll be bailed in and own shares in the banks you loathe.

        Have a small deposit? Keep it. Nobody will be lending so even the 50% cheaper houses will still be inaccessible.

        The super rich with connections and access to the government printing machine will make out like bandits.

        What? You thought a housing crash would be like Robin Hood? No no no.

  4. Jake GittesMEMBER

    We need evidence that lap dancers have 5 interest only portfolios before it becomes serious.

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

    No No No No No. Rule number one in the specufestor handbook – never, ever pay anything off. Keep acquiring more leverage, because that is wealth. What planet is this guy on?

    • Correct, also don’t pay down anything because then you cannot be negatively geared and getting a tax break is the #1 goal of any Australian.

      On a serious note: Someone once told my partner’s mother that you should never pay off your debt because then you can’t negatively gear… At first I was like what an idiot, then I was like… that’s Australian’s for you.

      • darklydrawlMEMBER

        hahaha… How true. The best ‘advice’ I have been told I was ‘don’t earn too much’ as you won’t get a health care care and all the concessional benefits. The great Aussie dream lives on. I just need to get on the Disability payment I will be sweet! 😉

  6. Interest only loans, both the people selling them and the people taking them on, are really risky and everyone should know much, much better.

    I find it stressful enough paying off a relatively small mortgage (2-3 years’ salary), you can’t help but worry about job security or what could happen to stability of the banking system even in that short time. Interest only should cause any sane FHB a significant amount of anxiety given the huge number of unknowns over a 10 year period. For one thing house prices don’t always go up so the CG aspect is hardly guaranteed!

    • LOL, yeah I was asked by my Mortgage Broker if i wanted to do Interest only and I said NO WAY! I am the sort of person who hates being in debt. I recall taking out a $5k loan once to help my partner buy a car (she had bad credit rating at the time) and I was worried about paying that off (mind you it was 15 years ago now).

      So taking on 500k of debt makes me shit myself, but so long as it’s an asset I believe will benefit me in the long term and the repayments are similar to my current rental payments. I’m ok with that. Since you gotta live somewhere.

      • Totally agree Gavin, I hate debt too. The question of whether it’s a “forever home” or just “for now” should help guide the amount of debt you’re willing take on. $500k is a lot of money, but perhaps justifiable if you expect to live there for 15-20 years. I think it’s just all about compromise hey.

        I agree it’s crazy how much money the banks are willing to throw at us, it’s definitely important to know your own limits.

    • darklydrawlMEMBER

      Kipron, You’re an old Nanna and worry wort. This is Australia mate and the whole concept of ““If there is a correction in the property market or a downturn in the economy” is simply untrue. Can’t happen here maaaaaate…. We’re the clever country run by the smarter folks on the planet (and some of the best looking too I might add)…. this place is toast at some point.

      • Patience, my friend. In time, he will seek *you* out, and when he does, you must bring him before me. He has grown strong. Only together can we turn him to the Moron Side of the Force.

    • Give yourself to the Moron Side. It is the only way you can save your sanity….. Yes, your thoughts betray you. Your feelings for it are strong. Especially for… financial matters. Your feelings have now betrayed them, too.

  7. If first home buyers are not buying their “forever home” and intend on holding their first as an investment when upgrading it makes accounting/tax sense to go IO and put principal repayment funds into offset account (to use as deposit for next PPOR).

    I would be interested to know how many FHBs who are IO also have an offset account.

    I have no doubt that it is also increasing as a result of worsening affordability, but there could also be a smart aspect for some choosing the IO option.

    I note the article didn’t actually provide any stats on the increase in FHBs using IO, are they available?

    • Very good point. Just because it is IO doesn’t mean you can’t effectively pay it off as quick and a P&I loan via an offset account.

      And from what I can tell as well, the banks don’t lend you more because it is IO rather than P&I (frankly, the increased interest rate offsets a lot of the cashflow benefits).. So I don’t see that this is a big issue.

      Once again, financial education is probably a issue for many borrowers.

    • +1 and also to be fair to the article above, IO even with an offset are in a way riskier that P&I because nothing can stop me for example from pulling that money out of the offset account but in a P&I , one can redraw but the bank will have to agree on it first

    • BB, almost all loans should be IO with a corresponding offset in 99% of situations. This provides taxation flexibility and funding flexibility in the future. No one should be paying P&I unless they can’t control their spending.

      • “No one should be paying P&I unless they can’t control their spending.”

        i.e. most of the population 😉

        P&I will sometimes come with lower interest rate, so can be worthwhile for those who don’t need the flexibility of IO/offset or for those who require forced discipline.

    • The problem is that the repayment schedule will increase by 40% after 5 years, because your 30 year loan is now a 25 year loan. If you can’t refinance, you’re in a world of pain.
      IO only with offset account makes sense when it’s an investment property due to this tax loophole about offset account not being counted as repayment. For owner occupiers, it’s an adjustable interest rate loan.

  8. Most IO loans have offset facilities attached to them. All the above means nothing without getting that sort of data. My mortgage is an IO only with 100% offset facility. Been paying pretty much double the Principal value if i was on a P&I account and i know many people who do the same. So talking about IO only without mentioning offsets is half of the story and doesn’t paint the correct image of what’s actually happening,
    I’ve asked this before and i’ll ask it again, anyone knows where we can get the total number of IO loans with/without offsets? Does the RBA has any numbers like that or maybe the banks do?! Anyone ever released this sort of numbers?

    • The IO loan for many I have spoken to is basically a way to rent their property from the bank instead of a landlord, and sell it for a profit when they want to upgrade/move in a number of years time. So the data I think we really need is not just if there’s an offset account, but how the balance of the offset account changes over time compared to what a P&I repayment schedule would have been.

      • Ah, let me guess…..

        Dad; If you borrow money from a bank to buy your dream home you pay 6%. If you borrow the same house directly from a landlord or a rental agency you pay 2%. Which is better?

        Kid; 6%!!

        Dad; Well done, son. I am so proud of you.

      • Furthering this is the advice (usually from a broker) to use IO and offset so that you can build the deposit for the next house and can keep the first for NG purposes – more ATO friendly than draining the equity from a redraw

      • IO loans are predominately used as a forward looking tax planning tool to take advantage of negative gearing. For example a junior doctor earning $120K PA, is buying a first home for $500K because that is sensible on his or her income. The correct way to structure this is to get the biggest loan possible without paying LMI. In this case it would probably be 90% or $450,000. The Dr only has to have a deposit of $50k, borrows the $450k IO and uses an offset account. All free cash flow is directed to the offset.

        In 10 years time when the same Dr is a specialist earning $350K and has a family, naturally they are in a position to upgrade the family home. Say he has $400k in the offset at this time. If he wants to keep the initial residential property as an investment, he can simply draw down the $400k in the offset as a deposit on the new mansion that costs a million. This means he needs to borrow $600k for the new place that isn’t tax deductible, instead of the full million not being deductible. The original home still has a loan of $450k and this is now fully deductible.

        IO loan data looked at in isolation does not tell you much, without knowing what is sitting in corresponding offsets. Though HnH is correct in surmising that it is a worrying sign that these loans are growing for first home owners, because mostly they are doing it for affordability, so it is doubtful they can manage to top up any offset very much at all.

      • “Where do you get a mansion for $1 million these days?”

        Good point. Poor choice of wording. I should have said a dog box within 10km of the CBD.

    • My manager does the same. Has IO mortgage and offset account. So it’s relatively common I’d imagine.

    • Exactly right. In the old days, people would first buy Property A to live in, and then buy Property B to rent out. Today, they can no longer afford to buy Property A first, so they instead buy Property B first and Property A afterwards. The technicalities of the Australian tax system require an interest-only lone in the latter situation but not the former.

    • But what if they have lower income in the coming years? This old mantra about borrow as much as you can and let income growth eat away at the serviceability is really being tested now.

  9. [email protected]

    If you calculate the cost of interest and other expenses including strata fees, you’ll soon realise there will hardly be any rental net return except for negative gearing tax refund. The theory says maybe rents will rise over time, which is doubtful considering the number of competing dwellings so the only hope is capital gain.
    This truly is a recipe for disaster as has happened everywhere else they overbuilt to buggery!

  10. Sydney western suburbs 2-bed unit:$750,000 @ 5% interest only:$37,500p.a.
    Interest rates normalise to 10%:$75,000p.a.
    New buyer can only afford $37,500 p.a. payments.
    New price for same unit:$375,000.

      • When it all crashes and most people have nothing, who is there left to buy Australian government debt unless the price of that debt is over 10%.

        Also check interest rates for home loans over the last 40 years
        at the RBA site…you’ll find that 10% is normal.

      • 10% is a long way away. When it was normal, inflation was high.

        If inflation goes up, the wages of the borrower in your example will go up as well.

      • Jason,
        Inflation has gone up. They just forgot to add the cost of accommodation to the figures. No doubt an innocent mistake.

      • Rates are low because the balance of business to home lending has become askew on the premise that housing is low risk. That inflated house prices. The inflated house prices and stagnant wages mean that the risk on home lending is actually higher than is traditionally assessed. Once the risk on home lending becomes evident, the cost of liquidity for housing will go up (even if the cash rate goes down). GFC v2.0.

  11. In addition to my above point, while some borrowers may opt for interest only, they are being assessed for serviceability at a higher interest rate (and based on P&I repayments), I don’t think a direct comparison to subprime is very reasonable.

    • Assuming that contents of their loan application isn’t entirely fabricated to “get them over the line”.

      • You have hit the nail on the head Dan. It all comes back to lending standards. Their is no problem giving a junior doctor a 90% IO loan, because pay rises are built in. Different story if banks are giving FIFO workers a large IO loan or someone in an industry where work or pay rises are not guaranteed.

      • @JC you’re right, and what irks me is that the subject of loan application fraud is completely ignored when offsets are wheeled out to explain away the surge in interest only lending for PPOR.

        I personally know three couples who were unable to obtain finance from a bank and had to go through brokers (who they subsequently recommended to me and my wife). One couple in particular had no deposit and used the equity in a flat one of them had bought back in the early noughties to secure a loan via a broker – they even borrowed to pay stamp duty. In the end they managed to borrow over a million clams. After a year they moved out of the place and stuck a tenant in there.

        There’s absolutely no way their brokers didn’t fudge or entirely falsify details on their applications in order to get the loans over the line. It’s terrifying that this sort of fraud, facilitated by brokers, is entirely ignored by industry, government, and the great unwashed.

  12. Long time readers know that my view has been that our bubble can grow much bigger and for much longer than people here appear to think.

    http://www.macrobusiness.com.au/2013/09/chinese-buying-unprecedented-sydney-property/#comment-278634

    http://www.macrobusiness.com.au/2013/10/apm-house-prices-lifted-in-september-quarter/#comment-291317

    It has also been my view that (1) the prevalence of the likes of 99 year loans and (2) widespread despondency among the bears / would be buyers will mark the top.

    I wonder if the prevalence of interest only loans is equivalent to (or worse than) the prevalence of 99 year loans. After all, interest only loans are equivalent to infinite year loans.

    • Jumping jack flash

      +1.
      Everything can and will be thrown at this.
      After all, it is the new economy.

      Debt growth is now economic growth, and it conveniently allows the RBA to control the entire economy with the interest rate lever. Maybe a couple of other buttons too, but the fundamental thing is, controlling the debt and debt “velocity” controls the economy.
      There is no reason to change it. They like it this way.

    • The US has had zero interest rates for 8 years now…insurance companies, pension funds, banks and the 99% of residents are hurting hugely.
      When the US crashes, we crash.

    • truthisfashionable

      I did some research on the weekend around home loan rates.

      USA current Average 30yr mortgage rate is 3.42%
      According to the ever reliable Yahoo! finance
      http://finance.yahoo.com/news/average-us-30-mortgage-rate-142723777.html

      And in Aussie land, the best rates seem to be around 3.41% pa
      http://www.yourmortgage.com.au/
      Remembering that banks will only offer 5yrs fixed here because the C-suite need their short term bonuses.

      Not sure how much lower we can really go on mortgage rates

      • darklydrawlMEMBER

        Keep in mind that the US rates are (generally) FIXED for the life of the loan – they generally offer 10, 15, 20 and 30 year fixed loans. Bonus is if rates go down you can refi at the lower rate. If they go up, you keep paying your original fixed rate as per the loan terms. It’s a great deal vs what the Oz banks offer mugs here.

      • and principal place of residence mortgage interest in the US is a tax deduction
        and some US states that offer no recourse mortgages – Alaska /Arizona/California/Connecticut/Idaho/Minnesota/North Carolina/North Dakota/Texas/Utah/Washington

  13. Jumping jack flash

    Safe as houses, mate!
    Government guaranteed capital gains in Australia, mate!

    Interest only is probably the last bastion of hope for those poor deluded people wanting to take on a debt mountain to give to someone else to make them instantly rich beyond reason.

    • Devil’s advocate here but in 2013 when I returned to Australia after living in Europe, if I had of taken out a mega mortgage and paid interest only over the last 3 or so years, even with stamp duty etc.. Instead of renting (which is around 90k+) I probably would be a couple of hundred thousand ahead of where I am now.

      Of course timing is everything…

      • I understand that situation.
        This shows up central bank stupidity: they should never have allowed “emergency” interest rates to last this long because it destroys the economy…and so goes the spirit.

      • You are fulfilling your destiny, Gavin. Become my apprentice. Learn to use the Moron Side of the Force.

      • @athalone the only emergency we have is hyperinflated/ing house prices, which requires a decade of emergency high rates 😉

  14. This country rewards conservatism, it’s a conservative country. I honestly don’t think this will change as it’s the values this society is based on whether we admit it or not. It’s all through our economics as well, just painting a picture, the status quo remains. Feels to me like this blog is some rebellious punk band trying to change things. The property bubble is apart of it, tis a shame, the last real left leaning prime minister (gillard) couldn’t even really be herself and it turned the political climate nasty as the tories were pissed she even attempted. Property prices went down in Sydney 10% or do during her reign, which was a good thing, she upset the “consumer sentiment” but the economy was fine. Still Abbott successfully branded her a disaster, talk back radio helped him, furthering the conservative brand and way of thinking in our political climate. Imagine what will happen when Hillary gets in lol WW3 on the way? Maybe it’ll usher in a more liberal way of thinking across the world and in economics, ha… doubtful. Australia needs another hawke-keating style of reform to come in to save itself, as we all know, I don’t think Mal’s up to it – nothings changing, the conservatives are winning.

    • jazzy The Hawke/Keating financial reforms” are at the core of our problems. They weren’t reforms as such. They were viewed as a necessity to maintain and then expand an already distorted economy.

  15. Aren’t all ‘variable’ loans ARMs? Its pretty hard to get a >5 year fixed rate loan in Australia. I think CBA does 10, but I don’t recall seeing 20 year fixed mortgages.

    • darklydrawlMEMBER

      Yes, to use the US term, Practically all Aussie loans are ARM’s. You can get fixed (or hybrid) loans, but the fixed bit is only for a limited time and usually with a fat margin built in as well. Even IO loans usually have a limit before the revert to P&I. The US offers much more secure and attractive loan structures than anything I have seen in Oz (at least for the average mug punter).