Interest-only with offset: a winning product?
Interest only loans for residential property purchase, for both owner occupiers and investors, have been in the news lately. With no requirement to repay principal, the concern for financial regulators is that many borrowers don’t have the incentive to build sufficient equity “buffers” to cope with any falls in housing values and/or rising interest rates.
The rapid growth in interest only loans was considered such a threat to financial stability that in March last year the Australian Prudential Regulation Authority (APRA) placed a 30% cap on interest-only loans as a share of new bank housing loans.
In October 2017, Westpac chief executive, Brian Hartzer, made the shock admission to the Parliamentary Standing Committee on Economics that about 50% of Westpac’s housing loans were interest only. He also explained that his bank was expecting to comply with the APRA requirement by making interest-only loans considerably more expensive than traditional principal and interest loans.
In response to the following question from the Committee chairman:
“ … so basically half of all people who have a mortgage with Westpac are not paying back any principal, they are just paying interest?”
Hartzer defended his bank’s position by noting that many interest-only borrowers voluntarily repaid principal or held significant balances in offset accounts:
“so the amortisation of interest-only accounts is roughly similar to the amortisation of someone who structured the product as principal and interest. People do that for tax reasons and they do it to manage their cash flow.”
Before responding to Hartzer’s defence, it may be necessary to explain what an offset account is. It’s a savings or transaction account linked to a mortgage. The balance of funds in this account is offset against the mortgage, for interest calculation purposes i.e. interest is only payable on the net balance. However, the owner is free to withdraw any funds from the account whenever they like.
A large percentage of interest-only loans now come with an offset account facility. This combination is the latest evolution in housing loan products that forty years ago comprised only principal and interest loans. Next came the ability to access equity built up in the value of your home (through loan repayments and/or valuation increases) that was then followed by loan redraw facilities i.e. ability to redraw loan repayments made ahead of schedule.
The benefits are great, but what about financial stability?
Undoubtedly, the latest housing loan incarnation (i.e. interest only loan with offset account) provides the housing borrower with many valuable features. As Hartzer suggested, it offers significant potential tax benefits.
For a residential property investor, the tax deductible character of the total interest only loan is always preserved despite the possibility that the net balance outstanding changes and may be significantly less. For the owner-occupier, the funds in the linked account effectively earn the after-tax interest cost of the mortgage i.e. rather than the usual lower pre-tax rate on a stand-alone deposit account, on which tax must then be paid.
The arrangement also simplifies cash management. Provided all cash inflows (e.g. salary, dividends, etc.) are directed to the linked account, with expenses deferred by disciplined use of a credit card, the net loan balance and interest payments are automatically minimised.
And, clearly, Westpac (and the other major banks) had little difficulty in selling the combination. An apparent win for both customers and the banks, so what could be the problem. When assessing the implications for financial stability of growing household debt, the Reserve Bank (RBA) suggests that, at the aggregate level, particularly when offset account balances are included (the dashed lines in the chart below), there is nothing to be concerned about. Both housing debt and interest to income fall considerably when offset accounts are netted off.
But, as the RBA has also previously acknowledged, financial stability issues arise with the marginal borrower rather than the average borrower. While the net interest-only loans and offset accounts balances may have behaved, in aggregate, similarly to that of principal and interest loans, at the individual borrower level this can’t be guaranteed.
For example, if a customer with a large offset balance feels wealthier because of a rise in house prices and decides to treat themselves to a new car, expensive holiday or major renovation, the apparent reduced net loan balance can virtually disappear overnight without the bank having any say in the matter. Under a standard principal and interest loan, the customer would have required, and may not have received, bank approval to access this “equity”.
In a similar vein, many young couples often seek the largest interest only loan with offset account they can, based on their current dual incomes. They expect that in the near future they will have children and become a single income household, at least for some time, and will struggle to meet interest payments (let alone, principal). Any surplus borrowing requirement is therefore placed in the offset account purely for the purpose of meeting future interest payments. For such borrowers, netting of loan balance and offset account to assess financial stability is illusory.
Interest-only with offset may be dynamite in the wrong hands
For disciplined cash flow managers, we think an interest-only loan with offset account is (subject to cost) a great product. But for those that are less disciplined or for those that are, or expect to be, financially stretched, they are potential dynamite.
By increasing the cost of interest-only loans to comply with APRA’s requirement, our concern is the banks may inadvertently light the fuse.
 i.e. after netting the linked deposit account balance.
 APRA requires banks to reduce the proportion of their interest only loans to 30% of all mortgages.