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UBS warns of widespread interest-only mortgage defaults in the next few years

Investors in bank shares should be alarmed by a shocking warning from a leading broker that 1-in-5 mortgagees on an interest-only (IO) loan is at risk of defaulting over the next few years.

UBS says the stress will come when IO loans mature and revert to principle and interest (P&I) loans when repayments jump, according to a report in the Australian Financial Review.

It is estimated that there are 1.5 million borrowers on IO loans worth nearly $500 billion which will convert to P&I loans over the next four years.

According to ASIC’s mortgage calculator, borrowers on an IO loan of $300,000 at 4% interest is likely to see their monthly repayments jump from around $1,000 to circa $1,700 (the longer your IO loan is for, the greater the increase when it converts to P&I).

In case you missed it, that’s a 70% increase in mortgage repayments and that’s not factoring in an increase in interest rates.

This probably explains why UBS believes 18% of respondents to its 2018 mortgage survey won’t be able to meet their monthly repayments when their IO loan rolls over. That equates to around 270,000 defaults just on IO loans.

Throw in higher interest rates and falling property prices, and this default estimate might prove to be somewhat conservative. We’ve already seen almost all banks, including our two biggest mortgage lenders Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC), lift rates independent of the Reserve Bank of Australia.

It’s also noteworthy that the big banks have been reducing their bad debt provisioning to boost profit growth in the past few reporting seasons. I will be keenly watching to see whether this trend reverses in the November profit season when Westpac, Australia and New Zealand Banking Group (ASX: ANZ) and National Australia Bank Ltd. (ASX: NAB) releases results.

One factor that could be compounding the IO loan issue is the general lack of understanding of the product. UBS was alarmed to find that a third of IO borrowers who are owner-occupiers had opted for the loan to benefit from negative gearing. Negative gearing is only available to investors.

Further, around 14% of these borrowers are house flippers. They plan to sell their homes at a profit before their IO loan expires. They probably missed the boat on this one.

While investors cannot afford to ignore this risk, banks may be able to manage the risk by extending IO loans. They are already curbing new IO loans and that could give them some flexibility to roll over these loans into another IO term loan over the next few years.

It’s kicking the can down the road – but that’s what central banks did during the GFC to get us out of the last mess.

Let’s just hope our chickens are on a long walk before they come home to roost.

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