In March last year, the Australian Prudential Regulatory Authority (APRA) implemented new rules to limit the number of new interest-only (IO) loans that were being written.

APRA instructed all banks to limit new interest-only lending to below 30% of new loans. Approximately 40% of all new Australian residential loans were interest-only at the time of APRA’s decree.

Interest-only loans are very popular amongst Aussie property investors because the interest paid on the loan is often claimed as a tax deduction.

Interest-only loans are typically for shorter terms (5 to 7 years) and don’t involve repayment of principal – so someone who borrows $500,000 will still owe that amount after 5 years. As a result, this type of loan is much favoured by property investors and speculators who bet on rising house prices. Interest-only loans are commonly seen as quite risky, however, especially if economic conditions change.

Australian banks like Commonwealth Bank of Australia (ASX: CBA) and National Australia Bank Ltd. (ASX: NAB) have historically written a significant number of interest-only loans. Westpac Banking Corp (ASX: WBC) has been one of the most active, with up to 50% of all its residential loans (46% as of 30 September 2017) being interest-only.

APRA’s ruling means that when previously written interest-only loans ‘roll over’ – when their 5 or 7 year loan period expires and they have to be refinanced – a significant percentage of borrowers won’t be able to continue in an interest-only loan. Principal and interest (P&I) loans have substantially higher repayments because borrowers must repay the principal (e.g. the $500,000) as well as the interest on that $500,000.

This so-called “P&I cliff” is expected to result in significant stress for a number of borrowers, as well as possible increases in bank bad loans – which are currently at record low levels. Martin North of property analysis firm Digital Finance Analytics was quoted in Fairfax as saying “This is horribly like the USA scenario with the reset loan rates that catalysed the global financial crisis… I think 2019-20 will be the crunch years in Australia.”

If the conversion from interest-only to principal & interest loans over the next few years results in as much borrower stress as is expected, it could have a significant impact on our banks and the property market, as well as consumer spending in the economy if people are forced to cut discretionary spending to pay down their loans.

As we recently wrote here, Aussie property investors could also be staring down the barrel of higher interest rates in coming years, if the forecasts of major economists are correct.

Now might be a better time than ever for property owners to take a look at their loans, negotiate with their bank, and build a healthy cash buffer.

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