Due to regulatory pressure, major banks have raised the interest-only rate on home loans. This puts mortgage borrowers most at risk.

While analysts, the media, and Australia’s governments regularly characterise those who take out interest-only loans as affluent property investors, the truth is, many owner-occupiers who’ve taken out such loans are using them to finance the purchase of the family home. Many of these borrowers are resorting to interest-only loans because their cash flow isn’t sufficient to repay interest and principal. 

Banks are feeling the heat

The banks are under regulatory pressure to convert their interest-only borrowers into interest-and-principal borrowers, and are offering little to no fees to switch over. The monthly payments will be higher due to the fact that the mortgage borrowers must also repay the principal. If they are able to afford it, many people will switch. There will be many people who can’t afford to make the switch.

The interest-only home loan rate at Commonwealth Bank of Australia was increased by 30 basis point on Tuesday. This follows similar actions by Australia and New Zealand Banking Groups, National Australia Banks and Westpac Banking Group. This was also the second major rate increase in just three months.

For the banks, the positive effect of the rate increases on interest-only loans will significantly outweigh the negative impact of the small drop in rates on interest-and-principal loans.

Macquarie research has shown that Westpac is the most competitive lender in terms of interest-only loans and could see a 3.5% increase in earnings.

No matter what type of borrower you are, this latest round of interest rate adjustments will have an overall effect on bank earnings. Borrowers will be required to pay more.

Young families most at risk

Martin North, principal of Digital Finance Analytics stated that rate adjustments are most dangerous to younger families. These are typically first-home buyers who’ve pushed their finances to the limit to enter the property market.

Both Macquarie analysts and North stated that both interest-only loans as well as the possibility of some switching to principal and/or interest could have negative consequences on the economy.

“The increase to [interest-only]When combined with loans, customers have the possibility to change to loans [principal and interest]This will result in further reductions in disposable incomes and more pressure on households with high debt levels. We estimate that a 50 basis point increase in interest rates has a 4 to 10 per cent impact on disposable income of highly indebted households,” Macquarie said. “While it would rationally make sense for many households (particularly for owner-occupiers) to switch to [principal and interest] …. many of these households would not have the capacity to do this.”