Written by Roger Montgomery (CEO Montgomery Investments)
For the last two years, we were feeling rather lonely suggesting that the property boom would end abruptly. Today, property prices are falling, and we are no longer a lone voice. The question is: how much further will they fall?
A number of changes are contributing to the declines in property prices.
For a start, rising bank fund costs are leading to higher mortgage rates. Then there’s a tighter definition of responsible lending following the Royal Commission – which will mean fewer individuals qualifying for a loan to buy property, and those that do get a loan will receive less. And on top of that, there’s been the introduction of lower debt-to-income limits and a wave of borrowers being migrated from interest-only loans – which hit a peak of $159 billion in 2015 – to principal and interest.
These structural changes will continue to impact property prices for some time.
One indication that prices might fall further than the 10 to 15 per cent suggested by some of my fund manager friends, is recent research produced by UBS that suggests the sanguine attitude held by borrowers towards their loans is misplaced. The research reveals a widespread lack of knowledge exists among borrowers about the terms of their interest-only loans and the extent of the increase in repayments that will need to be made when they are moved onto principal and interest.
UBS has uncovered some startling facts. When asked why borrowers took out an interest only mortgage, 18 per cent responded they “can’t afford to pay P&I”, 11 per cent said they expected house prices to rise and to sell the property before the interest only period expires and 44 per cent noted it gave them more financial flexibility. One can safely assume some proportion of the 44 per cent were also in the can’t afford P&I camp.
When combined, there are a substantial number of borrowers who have taken out an interest-only loan for the wrong reasons.
Moreover, many of these borrowers don’t understand the product they have been sold. Among owner-occupiers only 48 per cent understand their interest-only term expires within five years, which is the maximum term typically offered. Meanwhile 18 per cent observed they don’t know when their term expires and 8 per cent believe their interest-only term will last more than 15 years. A 15-year interest-only loan doesn’t exist.
The serious problem, however, is not that many borrowers will be shocked by how quickly their life will change, it is how much it will change.
34 per cent of all interest-only borrowers stated they “don’t know” how much repayments will rise. Meanwhile, 53 per cent expect repayments to rise up to 30 per cent and only 13 per cent of respondents indicated they expect their mortgage repayments to rise more than 30 per cent. Repayments will rise by at least 30 per cent and that is without interest rate rises in the interim.
UBS have gone a step further and calculated the step up for investors and owner-occupiers with a $600,000 interest only mortgage moving over to P&I. Depending on the duration of the principal and interest mortgage, the step up can be as much as 91 per cent! In other words for some borrowers repayments could double. Clearly, the majority of this cohort are unprepared or underprepared for the inevitable increases.
But why are we concerned? And why are all these people being forced onto principal and interest loans? The answer is APRA, in response to the Financial System Inquiry some four years ago. APRA imposed on the banks a strict limit of 30 per cent of all new mortgages written that can be interest-only. In 2014 and 2015 up to 49 per cent of mortgages written were written on interest-only terms but when these loan vintages mature in 2019 and 2020, only 30 per cent, including any brand new mortgages written, will be permitted to be on interest-only terms.
Of course the banks are fully aware of this situation and they understand that because it is the marginal seller of property – this weekend’s vendor – that will determine property prices for everyone, they must try to move as many people onto principal and interest that can afford it. That way those who can least afford the step-ups will be extended another interest-only loan for a further five years.
No wonder some of my friends who have mortgages – some have used them to fund purchases of real estate in Japan’s ski resorts – are already being asked to move over to P&I. By doing so it reduces the pressure on the banks to force people across who can least afford it.
Inevitably of course this creates an overhang of property that acts like a ceiling on prices at least until the next wave of buying breaks through it.
Until then expect even lower returns from residential property than those returns that were already locked in by paying a very high price.
