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Interest-only (IO) loans have long been somewhat of a scapegoat for the problems that have plagued the Australian banking sector over the last few years. With many IOs viewed as a type of loan that should only be handed out in specific circumstances, there are worries that the majority of individuals receiving these loans are unlikely to be able to pay them back.

It could pose a threat to the economy if these loans were all defaulted on at once, which is why the Royal Commission inquiry has strongly recommended trying to switch Australian citizens to a different type. Regulators have echoed these sentiments, and they are keen for banks and major lenders to switch IOs over to principal and interest payments (P&I).

The reason why so many of these loans are expiring in January is because their original terms have been in place for five years. Their natural end of life is in 2019, when the terms of these mortgages or loans will undergo renegotiation, but they will automatically become P&Is in the meantime. With so many of these loans changing, there is scope for some positive market outlook as more people slowly begin to acquire some of their assets through principal payments.

Reducing the levels of unsustainable and uncertain debts in the banking sector has long been one of the targets of the Royal Commission, which felt that IOs received priority through target-driven sales within each bank that resulted in more rewards for pushing this type of loan. The inquiry regularly lamented the culture leading to these choices, and now that many of these loans are naturally expiring, the Royal Commission will hope with good reason that the worst of this issue is over.

In a sure sign that measures from regulators are working, by the middle of 2018, IOs represented just 16.2% of the market total and were worth $61.2bn. However, at their peak five years ago, these loans were worth $295bn, making up a much higher 42% of all loans given out. When the Australian Prudential Regulatory Authority (APRA) took aim to improve this situation, it introduced a 30% market cap on how many IOs could be handed out in total. It removed this measure once it started to work.

According to research from Finder, a price comparison website, this may well have forced lenders to change their habits but has not necessarily changed demand. Initial figures suggest that between a fifth and a quarter of potential home buyers and investors are still seeking IOs as their first choice for borrowing money to fund their purchases. This indicates that although lenders are not using the practice quite as much, the current housing downturn has yet to have an effect on buyer sentiment and the idea of considering less risky loans.

Part of the reason that buyers choose IOs is that they are cheaper due to no principal payment being involved. Based on current mortgage rates, the change to P&Is would see the average Australian paying $400 more a year, but this may be worthwhile if more asset ownership takes place.