Australia’s Big Short

It is as if home loan applications are going back to the 1980s, when you needed to dress up in your best suit to meet the bank manager, to help make your case as to why the bank should lend you money.

One of the most recent red flags is the rise in interest-only loans. Sydney and Melbourne’s prices have exploded beyond belief and now, five years later, lenders are questioning their decision to allow borrowers to take out interest-only loans.

The latest stats say 40 per cent of home loans, not investment properties, are interest-only loans. Yes, that means those buyers have paid huge prices and budgeted to only pay the interest, instead of their loan.

Oddly enough, your borrowing capacity is reduced if you decide to take up an interest-only loan, even though the repayments are considerably less. The reason for this is because the lenders must take into consideration the loan repayment when the loan reverts back to principle and interest. Given you have now paid five years as interest-only, that means there are 25 years left on your loan term to repay the full amount, as opposed to 30 years.

And it is this is what could become Australia’s ‘Big Short’.

If you haven’t seen the movie The Big Short, it is about how one man predicted the US property market crash that led to a world-wide catastrophe. The Big Short, in short, is about what we would call ‘honeymoon’ or ‘intro’ mortgage rates that are sold to borrowers who could not afford them. After the three-year honeymoon period was over, the rate would revert to a much higher interest rate that the borrower couldn’t afford.

How did they get those loans approved? Because the banks were servicing the borrowers repaying the debt at the intro interest rate and not the ongoing interest rate, which was much higher, for the next 27 years. This occurred while the US property market was booming, so borrowers would simply refinance their loan to another three-year intro rate close to the expiry to avoid paying the high interest rates.

Now, all that makes sense, as long as house prices kept rising and there was enough equity in the property for the new lender to see a good deal.

And that’s where the problem started. Prices slowed and started to decrease so when these people tried to refinance, there was not enough equity in their properties for the banks to do the deal.

When the good times rolled, millions of people bought multiple houses because ‘everyone was doing it’ and making a killing in capital growth. They all believed that house prices never go down.

If you think believe that, you’re an idiot.

House prices decreased, loans reverted to much higher interest rates that the borrowers couldn’t afford and exactly what you thought would happen, happened. Yep, they defaulted and could not repay their loans and so started ‘the crash’.

Guess where the Sydney and Melbourne property markets are right now?

That’s right, at the end of a massive five-year boom where prices have now softened and even decreased slightly. We now have thousands of home owners and investors coming off their five-years interest-only period, meaning their repayments are about to jump significantly.

The scary part, the catalyst to this scenario, is that APRA has restricted the amount of interest-only loans that lenders can have. In response to this, lenders have tightened their lending criteria and made huge restrictions on their interest-only policies.

This now means that everyone with an interest-only loan is being put on notice. Unless you have 20 per cent-plus equity in the property and have exceptional servicing, you will probably not be able to extend your interest-only period with your current lender or be able to refinance to another lender for another interest-only loan.

Where this gets scarier and where borrowers may find themselves in financial stress is that when your loan reverts to principle and interest, it does so over a 25-year term instead of 30 years.

Let me explain. Say, you have an investment property loan for $500,000 and your interest rate is 4.5 per cent. Your monthly repayment would be $432 per week. When that loan comes off interest-only and reverts to principle and interest, your repayments are not based on the original 30-year loan term you originally applied for. As you have already had the loan for five years, you must now repay the full debt over 25 years, meaning your loan repayments increase to $640 per week.

That’s increase of $208 per week. Hopefully you don’t own several properties or have a home loan that’s interest-only too or you could be up for over $500 in extra payments per week.

Oh, and you better hope interest rates don’t increase as they have recently. That same scenario as above, but with 6 per cent interest rates would be an increase of $310 per week.

This will hit Sydney and Melbourne the hardest because they have extremely poor rental yields, and you will have to come up with the difference yourself.

This is only a problem if you have borrowed to your maximum and beyond your financial means. Or your income circumstances have changed, such as losing your job or starting a family.

For those who find themselves in trouble, the first thing they will do is sell their property to get out of financial strife. However, the market is changing and there will be far less buyers and prices will have subsided.

As their financial desperation kicks in, they will continue to reduce their selling price until they get a buyer. But there’s a kicker here. If they sell their property below what they owe, they either need to find the difference or shift the debt to another property. Failing which, the bank won’t release the title deeds to the new buyers.

Unlike the US, Australia does not have a non-recourse loan structure where you can simply drop the keys on the front door mat and walk away, leaving the house as the bank’s problem. That doesn’t happen here.

Over the years, I have been barking on about doing your own servicing at 9 per cent. If you can afford it at 9 per cent, you should be okay. The higher yielding areas I invest in certainly help, which is why I do it. Reduce risk and diversify.

This is one of those times where you’ll thank me for that advice or wish you had listened.

But if you think I am a doomsayer and choose to live in a fantasy world where house prices never go down, I hope you have the income to support it.