I recently had a chat with a mortgage broker.
Needless to say, he was trying to get me interested in the housing market…and sell me a mortgage.
I wasn’t biting.
But what got my attention was that he was mostly advocating interest-only mortgages.
In fact, as he told me, he had several himself.
If you are not familiar with interest-only mortgages, they have an initial term where you pay no principal, only interest.
Once the initial period is over, mortgage payments increase to include the principal.
According to the ABC, there is $640 billion in interest-only mortgages in Australia.
A large amount of these will need to start paying principal between 2018 and 2022.
And, as assistant governor Michele Bullock mentioned in a speech last week, the Reserve Bank of Australia (RBA) has their eye on them:
‘The increasing popularity of interest-only loans over recent years meant that by early 2017, 40 per cent of the debt did not require principal repayments. A particularly large share of property investors has chosen interest-only loans because of the tax incentives, although some owner-occupiers have also not been paying down principal. This presents a potential source of financial stress if a household’s circumstances were to take a negative turn…’
Is an interest-only mortgage more beneficial?
Interest-only mortgages may seem quite attractive at first. For one, opening payments are lower. This makes the loan look more affordable for people worried about taking on a large mortgage.
And with house prices climbing in recent years — much faster than inflation and salaries — that is a worry.
But you end up paying a lot more interest in the long term.
There was a great example of this in ASIC’s MoneySmart:
A family of four borrowing $750,000 over 30 years with a five-year interest-only mortgage and a 3.95% interest will initially pay $2,469 per month.
That amount jumps to $3,938 once the initial interest-only period is over…and the family pays an extra $48,304 in interest for the duration of the loan.
The spike in payment may not seem like such a huge deal to some. But, with expenses increasing and wages stagnating, finding an extra $1,469 a month can be tough.
So, why would anyone want an interest-only mortgage?
Well, the idea is that by the time you start repaying the principal, property prices will have increased. You then hold a more valuable property that allows you to either sell at a profit or renegotiate better loan terms.
That is something our friendly mortgage broker mentioned too — that you can keep extending the interest-only period. In other words, that you can keep kicking the debt can down the road.
That way, you can keep your money to invest in more assets…like property.
This all works well as long as house prices keep increasing at the same alarming rate they have done in recent years.
But if mortgage holders are under the impression that property always goes up, they should rethink this. We already saw during the US subprime crisis how property prices can plummet.
In fact, property prices are already slowing in capital cities. Renegotiating loan terms when property prices are on the way down won’t be easy.
If prices tumble, we could see a lot of people with higher mortgages than what their properties are worth.
Another problem is that some people may want to extend the interest-only period but they may not be able to.
As you can see in the table below, interest-only mortgages make up much of the Big Four banks’ portfolio.
[Click to enlarge]
Long-term effect of an interest-only mortgage
In early 2017, about 40% of new housing loan approvals were interest-only.
Yet last march, the Australian Prudential Regulation Authority (APRA) set the limit of new loans issued to 30%. Banks also increased rates by about 60 basis points to discourage them.
As a result, many may find it hard to renegotiate for a better loan, or they may not meet the lending criteria.
With salaries only growing at 2% and bills increasing, some could run into trouble to find the extra money for increased repayments. They may even have to sell.
Pressure could get worse for those with one or more investment properties.
According to the RBA, around two million people (approximately 11% of the adult population) had one or more investment properties in 2014/15. In that year, the number of investors with five properties grew by 7.5%, a much larger figure than the average 4.5% growth seen in the previous nine years.
And there is the added risk of rising interest rates. Asset values could collapse if interest rates rise. With such high mortgage debt, this property market may only be sustainable as long as interest rates stay low.
It doesn’t look like the RBA will be raising interest rates soon.
But, with high debt, higher bills and no extra money coming in, households are already feeling the squeeze.
We are saving less. The Australian household savings rate has gone from 5% at the beginning of 2017 to 3.2% in the third quarter of 2017.
As a result, we are starting to cut down on spending and consumption.
Consumption makes up 60% of Australia’s economy. If people start cutting their spending, the economy could take a downturn for the worse.
A slowdown could drive up unemployment and decrease house prices, as more homes go under the hammer to make ends meet.
Interest-only mortgage holders may end up with negative equity in their home and find it impossible to sell when they need to.
Markets & Money’s editor Vern Gowdie has been warning about the dangers of high debt levels for a long time. In fact, he is convinced the next ‘Great Crash’ is approaching. That’s why he has outlined a step-by-step plan to survive it.
To find out more, click here.
Editor, Markets & Money