Warnings as interest-only loans jump to highest level in seven years

• Interest-only loans made up 23.5 per cent of new housing lending in the June quarter, Australian Prudential Regulation Authority data shows.
• Investors took 68 per cent of interest-only lending, and 45.2 per cent of their new lending was on interest-only terms.
• Canstar estimates five interest-only years would add $70,915 in interest to a $600,000 owner-occupier loan.

Almost a quarter of new home lending in Australia is now interest-only, with experts warning the lower repayments can leave owner-occupiers more than $70,000 worse off over the course of their loan.

Interest-only loans made up 23.5 per cent of new housing lending in the June quarter, or $47.2 billion of $200.5 billion, according to the latest data from the Australian Prudential Regulation Authority (APRA), the banking regulator.

The rise leaves more debt intact as interest rates climb, exposing borrowers to higher lifetime costs and negative equity if property prices fall.

“While lower monthly repayments with an interest-only loan may look tempting on paper, the trade-off is clear: you’re not chipping away at your debt,” Sally Tindall, data insights director at financial comparison site Canstar, told The Money Edition.

APRA’s June quarter share is the highest in a series dating back to 2019, and up from 20.7 per cent a year earlier.

New interest-only lending jumped 21.6 per cent in a year from $38.8 billion, more than three times the 6.8 per cent growth in all new loans, APRA data shows.

Investors took $32.1 billion of the quarter’s interest-only loans, or 68 per cent, against $13 billion for owner-occupiers, and 45.2 per cent of their new lending was interest-only, compared with 10.5 per cent for owner-occupiers.

“It’s clear investors are far more likely to take out a new loan on interest-only terms, rather than an owner-occupier,” Tindall said.

“A lot of investors also try to maximise their housing debt by not paying down their loan as a tax strategy,” she added.

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The overall share remains well short of the 46 per cent reached in mid-2015, according to the data insights director.

With almost half of all new loans on interest-only terms at the time, Tindall said APRA stepped in with a cap, limiting interest-only loans to 30 per cent of new lending in March 2017, before announcing its removal in December 2018.

Across all term loans, $307.8 billion sat on interest-only terms in June, up 17.6 per cent in a year, compared with 7 per cent growth in total housing credit, APRA data shows.

That debt accounts for 12.1 per cent of term loans, including 30.5 per cent of investment loans but only 3 per cent of owner-occupier loans.

“While interest-only lending among new home loans has risen over the last few quarters, looking at the entire loan book there’s no evidence borrowers are switching to interest-only terms en masse,” Tindall said, pointing out that the share of all loans has dropped from 23 per cent in 2019 to 12 per cent.

“This is surprising, considering the rate tightening we’ve seen since 2022,” she said.

Why interest-only can backfire

“Choosing to go for an interest-only home loan means you’re solely covering the cost of borrowing from the bank, not paying off the actual debt itself,” Tindall said.

After the usual five-year limit for owner-occupiers, “the $600,000 debt on day one is still $600,000,” she said, and borrowers often pay more for the privilege, with banks that “typically charge higher interest rates for interest-only loans.”

Canstar estimates that new owner-occupiers will average a variable rate of 7.54 per cent on interest-only terms and 6.65 per cent on principal and interest once banks pass on the Reserve Bank of Australia’s (RBA) November rise.

“Interestingly, investors paying interest-only terms are, on average, paying a lower rate than owner-occupiers on the same loans,” she said.

“This is because investors paying interest-only are seen as lower risk than owner-occupiers who aren’t paying down their debt, because an investor can more easily sell their property if they need to.”

Owner-occupiers cop the worst of it, Tindall said, with Canstar modelling showing five interest-only years on a $600,000, 30-year loan save just $82 a month upfront but tack on $70,915 in interest over the life of the loan.

An investor on the same loan would save $415 a month at the start but pay an extra $50,048, Tindall said, with the modelling assuming rates move in line with Commonwealth Bank forecasts and excluding fees and extra repayments.

The negative equity trap

“Paying interest-only can be particularly risky if the price of the property begins to fall, particularly for those borrowers who start out with a small deposit,” Tindall said.

Her warning comes as home values slide, with Cotality’s national index down 1.2 per cent in October, its seventh straight monthly fall.

Values now sit 6.7 per cent below their March peak, wiping about $63,400 off the median dwelling, according to Cotality.

“If prices fall by more than the initial deposit amount, and a borrower has not made any headway into their debt, they will find themselves in negative equity,” Tindall said.

Negative equity means owing more on a loan than the property is worth.

“This makes it harder to refinance until the market recovers and / or the borrower starts paying off the money they owe, and if they need to sell, it will mean they have to stump up the difference between what they get back in the sale of the property and what they owe the bank,” she noted.

Less than 1 per cent of borrowers are in negative equity, but around 5 per cent of mortgages would be under a uniform 20 per cent fall in housing prices, the RBA said in its October Financial Stability Review.

Recent buyers and borrowers with higher loan-to-value ratios are more likely to end up there, the central bank said.

APRA data shows 29.7 per cent of new loans funded in the June quarter had a loan-to-value ratio of 80 per cent or more.

The RBA said interest-only loans slow the build-up of equity, but that their rising share of new lending is no cause for concern by itself.

It also said negative equity alone won’t trigger a default if borrowers can keep up their repayments.

Broader mortgage stress remains limited so far, with 0.54 per cent of housing credit 30 to 89 days past due in June and 1.01 per cent non-performing, APRA data shows.