Investors like this type of mortgage because interest is tax deductible, whereas capital repayments aren't. Photo / iStock
Investors like this type of mortgage because interest is tax deductible, whereas capital repayments aren't. Photo / iStock
An interest-only mortgage allows the borrower to pay just the interest on their loan, meaning the amount borrowed stays the same. But could it be a ticking time bomb?
Though interest only mortgage rates haven't caused a stir here, they were dubbed the "villains" of the property crash in the US during the subprime crises.
There have been warnings in the UK about interest-only loans because too many borrowers have no plan to pay back the principal at the end of their mortgage term. The authorities there have tightened up on these loans, which were being taken out for up to 25 years.
Across the Ditch, the Australian Securities and Investments Commission (ASIC) took action when interest-only loans as a percentage of overall new housing loan approvals hit a whopping 42.5 per cent.
Interest-only lending by local banks is growing, but hasn't yet reached Australian levels. Our Reserve Bank (RBNZ) says the proportion of interest-only lending by banks has increased in recent years and is currently about 53 per cent of lending to residential property investors and about 30 per cent of lending to owner-occupiers of residential properties.
The RBNZ says the overall average of both owner occupiers and investors combined is 38.1 per cent of lending by dollar value and 34.3 per cent by number of borrowers.
It says that percentage has risen, but isn't yet able to show the trend.
Mortgage broker Karen Tatterson of Loanmarket believes that despite the rise in interest-only lending New Zealand's banks are being responsible. In most cases she says the banks are reviewing interest-only loans after five years rather than the historical 10 years, meaning borrowers can't get away with rolling over interest-only loans.
When it comes to these mortgages, the scenarios relating to home owners and investors are different. Investors like this type of mortgage because interest is tax deductible, whereas capital repayments aren't.
With investors, says Craig Pettit, also of Loanmarket, most will pay off their personal debt first and then start paying principal and interest on their investment properties, eventually reducing debt and creating cash flow to live on.
One of the biggest risks isn't interest-only per se, says Andrew Bruce, president of the Auckland Property Investors Association. It's home owners and investors getting used to the low interest rate environment and then facing a shock if interest rates rise.
Mortgage brokers in New Zealand argue that limitations imposed by the Responsible Lending Code will ensure there isn't a GFC style meltdown here when borrowers' interest-free periods run out, says mortgage broker Geoff Bawden, of Bawden Consulting.
When the code came into force earlier this year the banks reacted and tightened their lending criteria, he says.
"The market has become totally consumed since the introduction of the Responsible lending Code with making sure everything is affordable," says Bawden.
In its May 2016 Financial Stability Report, the RBNZ voices concerns about the high share of lending being undertaken on interest-only terms or at high total debt-to-income multiples.
"As a result of persistent credit growth in excess of income growth, the household debt-to-income ratio has grown steadily since 2012 and now exceeds the previous peak reached during the GFC," the report notes. High and rising debt levels, it adds, left households vulnerable to an increase in mortgage rates or deterioration in economic conditions.
Despite the rise in interest-only lending New Zealand's banks are being responsible. In most cases she says the banks are reviewing interest-only loans after five years rather than the historical 10 years, meaning borrowers can't get away with rolling over interest-only loans.
Interest-only mortgages can be particularly risky for unsophisticated buyers who don't understand the risks and will pay far more interest over the life of their mortgage than they would have on principal and interest payments.
Another risk is rising interest rates. If borrowers are slowly paying down capital, the interest payments are reducing at the same time.
The longer they have the mortgage the easier, therefore, it will be to stomach any interest rate rises. With an interest only loan, borrowers can face the full shock of a rise.
Other risks include not being able to refinance, especially if the government increases minimum loan to value ratios. In a worst-case scenario owners who have taken interest-only loans could face a mortgagee sale and lose the home.
RBNZ survey data suggests that investors who take interest-only loans are likely to retain a higher level of gearing over the long term than their owner-occupier counterparts.
Although New Zealand has not experienced a financial crisis associated with the housing market, a range of international evidence suggests that defaults on investor lending tend to be significantly higher than for owner-occupiers during severe downturns.
Unsurprisingly the RBNZ says the risks associated with investor lending are greatest in the Auckland regions where rental yields, which are at record lows, have been depressed, with investors buying for capital gains rather than rental income.
