Following instructions from regulators, banks are set to increase their rates for interest-only home loans in an effort to push more people towards principal and interest loans.

If you take out an interest-only loan from a bank, the money you repay only covers the cost of interest – you never actually pay back any of the money you borrowed. This is a popular choice for investors and some first-home buyers who want to minimise repayments.

The big downside of interest-only loans is that if your home drops in value, the money you make from selling it won’t be enough to pay back your loan in full.

Rates going up

Back in March, the Australian Prudential Regulation Authority (APRA) told banks to reduce the proportion of new interest-only loans to 30%. Until recently, around 40% of new home loans were interest-only.

It seems that banks have reacted to this by upping rates on interest-only loans. Figures from RateCity show a relative increase of 0.56 percentage points compared to principal-and-interest loans.

The RateCity research showed that the average rate for interest-only loans is 4.88%, while for owner-occupiers who are making a dent in the amount they owe by paying back principal, it’s 4.31%.

And experts keeping a close eye on the mortgage market predict the gap will widen further as banks encourage customers to pay off principal on their loans in line with APRA’s cap.

“If APRA continues to apply pressure on the banks and brings other lenders under its control, the average gap is likely to widen by 20-40 basis points more,” said RateCity chief executive Paul Marshall.

Mortgage Choice chief executive John Flavell predicted the gap would widen to around 0.7 percentage points.

Interest-only loans are usually set up to switch to the principal-and-interest model after about five years.

“I would expect some pretty aggressively pricing in terms of people rolling over their interest on loans and encouraging them to go principal-and-interest,” Mr Flavell said.

“The difference between principal and interest-only loans will widen further.”

Will it work?

Mr Marshall questioned how effective the rate hikes would be at deterring buyers.

The real test will be whether investors can find the 20% deposit that banks are now requiring for interest-only loans, he suggested.

The winners from all of this may well be owner-occupiers with principal-and-interest loans, since competition among banks might lead to better deals on these products.

Earlier this month ANZ Bank hiked rates on interest-only loans for the second time in three months, but at the same time rates for principal-and-interest loans were cut.

The Bureau of Statistics revealed new lending to investors fell by 2.3% during April. This suggests that some customers are being put off borrowing altogether.

Aussie Home Loans chief executive James Symond said last month that APRA’s crackdown was impacting new interest-only lending, a channel mainly used by property investors.

“There’s no doubt that we are seeing these regulatory policies bite. If you look at interest-only loans, they are materially down year on year, as they should be,” Mr Symond said.

“You look at investment loans, they are down year on year as well because of these regulatory changes.”

He was positive about the owner-occupier market where there had been some growth in lending, even to first-home buyers. He also highlighted an increase in people refinancing their mortgages to get a better deal.

If you’re concerned about how these changes may affect your home loan, talk to us so we can help you to understand your options – we’re your very ‘unordinary’ finance people.