Last week, ASIC published its findings from an investigation into interest-only lending. The report also included the regulator’s recommendations to improve underwriting standards for interest-only (IO) loans. According to global ratings agency Moody’s, ASIC’s proposed recommendations for interest-only loans are “credit positive” for the mortgage market.
“The recommendations aim to improve the robustness of loan serviceability assessments for IO loans, thereby reducing payment shocks following interest rate increases and conversion to principal and interest payments,” Moody’s said.
“Additionally, ASIC’s recommendations emphasize that lenders, as part of their responsible lending obligations, must consider whether IO loans meet borrowers’ objectives, which is likely to lower IO loan use by owner-occupiers in the future given that the benefit of IO loan for owner-occupiers is not clear since they cannot deduct loan interest from taxes as investors can.”
Among ASIC’s recommendations for IO loans is calculating loan serviceability over the remaining principal and interest term of the loan, rather than the entire term inclusive of the IO period. According to Moody’s, a typical IO loan is five years, followed by a principal and interest period of 25 years.
“Calculating loan repayments on a $300,000 loan at a 5% interest rate over 30 years rather than 25 years underestimates a borrower’s monthly payment by $140,” the ratings agency said.
ASIC has also recommended that lenders should ascertain borrower-specific living expenses rather than simply relying on minimum benchmarks. Moody’s says this will reduce default risk of owner-occupier borrowers seeking an IO loan because principal and interest payments would stretch them financially given their actual level of expenses.
According to a Moody’s analysis, IO loans outperform principal and interest loans in low interest rate environments, however the trend reverses when interest rates rise, which makes these sorts of loans inherently risky.
“IO loans tend to have higher loan-to-value ratios, a key default driver, and slower prepayment rates. Additionally, borrowers with investor IO loans may rely on the sale of the property as the means of repaying their IO loans, a challenge if house prices decline, and may rely on rental income to meet their serviceability, which may not be adequate as rates start to rise.”
