Currently, 42.3% of all housing loan approvals are for interest-only home loans. They have increased in popularity by 78% over the past three years 2012-2013-2014, compared with a 25% increase in principal-and-interest home loans over that same period.
Home buyers and investors like interest-only loans because they are affordable and flexible. Lenders like interest-only loans because they receive more interest over the loan term. Mortgage brokers like interest-only loans because they fit the borrower’s requirements and they receive more commission.
But the financial regulators are concerned about the risks – that interest-only loans may be unsuitable, and the higher loan repayments may be unaffordable if the borrower’s financial situation changes and when the initial interest-only period ends.
REP 445 now released by the Australian Securities & Investments Commission (ASIC) (supported by the Australian Prudential Regulation Authority (APRA)) has exposed poor credit assessment practices by lenders and mortgage brokers for interest-only home loans. Hence ASIC’s calls for action for improved lending standards.
ASIC Report 445 – Review of interest-only home loans
In December 2014, ASIC commenced a review of interest-only loans. The review covered both owner-occupier home loans and residential investment loans.
Phase 1 of the review was to survey both ADI (Bank) and non-ADI (non-Bank) lenders to collect data and assess their responsible lending policies. Phase 2 was to review 140 actual loan files to assess compliance with responsible lending obligations.
ASIC released REP 445 in August 2015. ASIC made 6 key responsible lending findings and sets out 10 actions that it recommends that Australian Credit Licensees follow. The findings made and actions recommended are to clarify the Obligations of credit assistance providers under the
National Consumer Credit Protection Act 2009 (National Credit Act) and to supplement ASIC Regulatory Guide 209 Credit licensing: Responsible lending conduct (RG 209).
REP 445 Survey conclusions
Most of the loans reviewed had a term of 30 years, with the first 5 – 10 years interest-only, and the residue of the term principal-and-interest.
ASIC gives an example of a $500,000 home loan over 30 years, the first 5 years interest-only, then 25 years principal-and-interest, at 6% pa interest. The consumer will pay additional interest of $37,226 over the term compared with a 30 year principal-and-interest loan. Also, when the 5 year interest-only period ends, the repayments will increase from $2,500 pcm to $3,242 pcm.
Owner-occupiers and investors see benefits in interest-only loans for these reasons:
- Future investment use – the property may be owner-occupied in the short-term, then it becomes an investment property. An interest-only loan will maximise future tax benefits.
- Flexible repayments – interest-only payments cater for variable or unpredictable incomes (casual, self-employed, overtime, commissions, bonuses), temporary income reductions (unpaid maternity leave) and costs associated with a house purchase (moving, furnishing).
- Redirect cash flow – interest-only payments means that surplus funds are available for non-recurring expenses, discretionary expenses (a holiday or new car) and other investments.
- Temporary finance – use as bridging finance, during construction, or until another property is sold to pay down the loan.
- Investors – use interest-only loans to maximise cash flow, as well as tax deduction benefits.
Lenders allow consumers to deposit lump sums to reduce loan balances by way of offset accounts.
The financial regulators see affordability risks when the repayments increase at the end of the interest-only period, the risk of negative equity if property prices fall during the interest-only period, and the consumer not understanding that more interest is payable under an interest-only loan.
REP 445 Review Finding 1: Lack of evidence of inquiries into requirements and objectives
The National Credit Act states that a credit contract will be unsuitable if it does not meet the consumer’s requirements or objectives (s. 118(2)(b)). ASIC is concerned that lenders do not give sufficient consideration, and in 30% of loan files no consideration, to borrower requirements and objectives. ASIC has recommended:
Action 1 Lenders and brokers must look carefully at whether the specific features, benefits and costs of interest-only loans meet the consumer’s objectives. The reasons listed above - why borrowers like interest-only loans - are a useful guide.
Action 2 Lenders and brokers should offer interest-only periods which are aligned with the consumer’s requirements and objectives. These periods should not exceed five years unless there is a clear reason.
REP 445 Review Finding 2: Affordability and interest-only
The National Credit Act states that a credit contract will be unsuitable if the consumer will be unable to comply with their financial obligations (or comply only with substantial hardship) (s. 116, s. 118(2)(a)). ASIC is concerned that the consumer has an appropriate income surplus to withstand a reasonable fluctuation in income or expenses or an interest rate rise. ASIC has recommended:
Action 3 Lenders need to apply both an interest rate buffer not only to the proposed loan but also to existing credit contracts when assessing affordability. APRA advises a minimum interest rate buffer of at least 2%, and a minimum floor rate of at least 7% (lenders are to use the higher of the two).
REP 445 Review Finding 3: Variation in treatment of volatile and irregular income
The consumer’s income to meet their financial / repayment obligations (see s. 117(1)(b) & (c) National Credit Act) is assessed by the lender making reasonable inquiries, and by taking reasonable steps to verify that income. ASIC in RG 209 requires lenders to confirm income by looking at pay slips, tax returns, bank statements and rent statements. ASIC has recommended:
Action 4 Lenders must discount or disregard high or volatile income when there is uncertainty on its continuity. A rental discount of 20% is appropriate for outgoings, repairs, managing agent fees and vacancies, but can be too little when strata levies are high. The negative gearing tax benefit can be taken into account in serviceability calculations.
REP 445 Review Finding 4: Lack of evidence of inquiries into expenses and reliance on benchmarks
The consumer’s expenses need to be assessed by the lender making reasonable inquiries, and by taking reasonable steps to verify, those expenses. In 20% of loan files reviewed by ASIC, benchmarks were used with no verification when a lender assessed the consumer’s financial situation. ASIC has recommended:
Action 5 Lenders must inquire into and verify fixed expenses (rent, debt repayment, child support and insurance) and living expenses (food and utilities) and must document what they have done.
Action 6 The more detailed the breakdown of expenses, the better. Lenders can use benchmarks, such as the Household Expenditure Measure (HEM). But if they do so, they must use income-adjusted benchmarks to reflect the reality that consumers with higher income will have higher living expenses. If the actual expenses exceed the benchmark, then the benchmark cannot be used.
Action 7 Lenders need to verify the amount of the existing debt and the repayments.
Action 8 Lenders need to identify inconsistencies in the information provided, make additional inquiries to assess affordability, and document the outcome.
REP 445 Review Finding 5: Capacity to pay after interest-only period not based on residual-term payments
The National Credit Act assessment of a consumer’s capacity to meet their financial obligations (see s. 117(1)(b) & (c) National Credit Act) needs to be made on the payment term. ASIC has recommended:
Action 9 Lenders must not calculate loan affordability based on principal-and-interest payments for the full loan term, because it produces a lower figure than if the calculation were based on the actual principal-and-interest repayments for the residue of the term.
REP 445 Finding 6: Lack of flexibility for hardship variations for interest-only home loans
Most lenders had financial hardship policies which did not distinguish between interest-only and principal-and-interest home loans. Some had more restrictive options for interest-only home loans. ASIC has recommended:
Action 10 Lenders must review their hardship policies, the options available, and assess the most appropriate outcome of a hardship application on a case-by-case basis for interest-only loans.
Interest-only loans are a significant and popular home loan product in Australia.
The actions that ASIC recommends that lenders and brokers take are directed to improving their responsible lending practices, to comply with the National Credit Act and RG 209.
ASIC noted that the 11 lenders (including the big four banks) who participated in the review have agreed to implement the actions ASIC has recommended. Those lenders will be making sure that their mortgage brokers implement the actions.
ASIC provides these warnings to the lending industry, including brokers:
We expect all lenders to review their procedures in the light of our findings ... Where we identify breaches of the law, we will consider enforcement action or other appropriate regulatory action.
For background information - Why interest-only loans are being restricted in Australia
For ASIC Review: REP 445 – Review of interest-only home loans