Why interest-only home loan stats don't add up

  • By Elizabeth Fry

Almost one month after UBS analyst Jonathan Mott warned that a third of borrowers who took out a mortgage in the past 12 months were overstating their income, he has sounded the alarm over the lack of financial literacy in Australia. This is especially the case with interest-only loans.

After Mott’s explosive report in September - which concluded that the country’s banks could be sitting on $500 billion of “liar loans” - he is now claiming that one third of borrowers with interest-only home loans do not realise they are failing to pay off any of the mortgage’s principal amount.

“Although this may seem far-fetched it needs to be considered in the context of the lack of financial literacy in Australia,” said Mott.

Upon fresh analysis of the September survey, one curious statistic caught his eye.
 

Odd mortgage stat

Mott saw that 24 per cent of borrowers said they were on an interest-only loan. The problem is this is a substantially lower figure than was released by the government statistician, which put the interest-only loans in the market at 35 per cent and worth about $640 billion.

The analyst dismissed the idea that the difference could be due to a sample error, arguing that the probability of survey sample being so far from the system is a negligible 0.1 per cent.

“A more plausible explanation is that around one-third of interest-only customers do not know or understand that they have taken out an interest-only mortgage,” he argued.

He pointed to a recent survey by Standard & Poor’s that found 36 per cent of Australians were not financially literate, while an ME Bank survey found 42 per cent did not understand compound interest. ME Bank further backed Mott’s findings by stating 38 per cent had no understanding of an interest-only mortgage.

“We are concerned that it is likely that approximately one-third of borrowers who have taken out an interest-only mortgage have little understanding of the product or that their repayments will jump by between 30 to 60 per cent at the end of the interest-only period,” Mott said.

The bigger issue for the analyst is how these interest-only mortgage customers - with little knowledge of how these home loans work - will respond to higher rates.
 

Mortgage stress

Mott pointed out that the survey was taken after the banks repriced their mortgage books in June and so interest-only borrowers were asked whether they suffered financial stress following the rate hikes.

Around 26 per cent of respondents said they were under ‘no’ stress or ‘low’ stress with 35 per cent claiming to be under ‘moderate’ stress. A solid 36 per cent indicated they are already under ‘high’ stress, the UBS research found.

More than half of interviewees surveyed said that they are reacting to higher interest rates by reducing consumption, while 24 per cent are considering switching to principal-and-interest loans.

“Of concern, 23 per cent of interest-only borrowers who are already under high stress said they are considering selling their property, while 17 per cent will need to draw down other lines of credit to meet higher rates,” he said.

“These findings are concerning, in our view, given there are $640 billion of interest-only mortgages outstanding in Australia, representing 38 per cent of the banks' mortgage books and 24 per cent of all Australian credit.

“While these loans are well secured, we believe many borrowers may face substantial stress as interest rates rise or when they revert to principal-and-interest. We also believe mortgage mis-selling and responsible lending obligation risks cannot be ignored.”

Mott's view is consistent with the house view that the full impact of macroprudential policy tightening is still yet to hit.