It’s feeling like home loan applications are going to go back to the 1980s, when you needed to dress up in your best suit to meet with the bank manager, to help make your case as to why the bank should lend you money.

One of the most recent red flags that have arisen is the rise in interest only loans. Sydney and Melbourne’s prices have exploded beyond belief and now, five years later, the lenders are questioning their decision to allow borrowers to take out interest-only loans.

The latest stats say 40 per cent of home loans, not investment properties, are interest-only loans… yes, that means those buyers have paid those huge prices and budgeted to only pay the interest, not actually repay their loan.

Oddly enough, your borrowing capacity is reduced if you decide to take up an interest-only loan, even though the repayments are considerably less. The reason for this is because the lenders must take into consideration the loan repayment when the loan reverts back to principle and interest. Given you have now paid five years as interest-only, that means that there are 25 years left on your loan term, to repay the full amount, as opposed to 30 years.

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And it is this which could become Australia’s Big Short.

If you haven’t seen the movie The Big Short, it tells the story of how one man predicted the US property market crash that then led into a world-wide catastrophe. The Big Short, in short, is about what we would call ‘Honeymoon’ or ‘Intro’ mortgage rates that are sold to borrowers who couldn’t afford them. After the three-year honeymoon period was over, the rate would revert to a much higher interest rate that the borrower couldn’t afford.

Then how could they get those loans approved? Because the banks were servicing the borrowers repaying the debt at the intro interest rate and not the ongoing interest rate, which was much higher, for the next 27 years. This occurred while the US property market was booming, so borrowers would simply refinance their loan to another three-year intro rate close to the expiry to avoid paying the high interest rates of course… that they couldn’t afford!

Now all that makes sense – as long as house prices kept rising and there was enough equity in the property for the new lender to see a good deal.

And that’s where the problem started. Prices slowed and started to decrease so when these people tried to refinance, there was not enough equity in their properties for the banks to do the deal.

While the good times were around, millions of people bought multiple houses because ‘everyone was doing it’ and making a killing in capital growth. They all believed that house prices never go down.

If you think that – then you’re an idiot! Yes, that’s right – an idiot!

House prices decreased, loans reverted to much higher interest rates that the borrowers couldn’t afford and exactly what you thought would happen, happened! Yep, they defaulted and couldn’t repay their loans and so started ‘the crash’.

Guess where the Sydney & Melbourne property markets are right now?

That’s right – at the end of a massive five-year boom where prices have now softened and even decreased slightly, and we have thousands of homeowners and investors coming off their five-years interest-only period, meaning their repayments are about to jump significantly.

The scary part, the catalyst to this scenario, is that APRA have restricted the amount of interest-only loans that lenders can have. In response to this, lenders have tightened their lending criteria and more so have made huge restrictions on their interest-only policies.

This now means that everyone with an interest-only loan is being put on notice. Unless you have 20 per cent plus equity in that property, plus have exceptional servicing, you will probably not be able to extend your interest-only period with your current lender or be able to refinance to another lender for another interest-only loan.

Where this gets scarier and where borrowers may find themselves in financial stress is that when your loan reverts to principle and interest, it does so over a 25-year term, not 30 years.

Let me explain:

Say you have an investment property loan for $500,000 and your interest rate is 4.5 per cent. Your monthly repayment would be $432 per week. When that loan comes off interest-only and reverts to principle and interest, your repayments are not based on the original 30-year loan term you originally applied for. As you have already had the loan for five years, you must now repay the full debt over 25 years, meaning your loan repayments increase to $640 per week.

Yes, an increase of $208 per week. Hopefully you don’t own several properties or have a home loan that’s interest-only also, otherwise you could be up for over $500 in extra payments per week – not per month!

Oh, and you better hope interest rates don’t increase like they have done recently, too. That same scenario as above, but with six per cent interest rates would be an increase of $310 per week.

The reason this will hit Sydney and Melbourne the hardest is because they have extremely poor rental yields, meaning that you have to come up with the difference yourself.

Now this is only a problem if you have borrowed to your maximum and beyond your financial means. Or your income circumstances have changed, like job loss, job change or started a family.

For those who find themselves in trouble, the first thing that they will do is sell their property to get out of financial strife. The issue being that the market is changing and there will be far less buyers, meaning prices will have subsided.

As their financial desperation kicks in, they will continue to reduce their selling price until they get a buyer. But there’s a kicker here; if they sell their property below what they owe, then they either need to find the difference, shift the debt to another property or the bank won’t release the title deeds to the new buyers.

Unlike the US, Australia does not have a non-recourse loan structure where you can simply drop the keys on the front door mat and walk away, leaving the house as the bank’s problem. That doesn’t happen here.

Over the years I have been barking on about doing your own servicing at nine per cent. If you can afford it at nine per cent, then you should be okay. The higher yielding areas I invest in certainly help, hence that’s why I do it. Reduce risk and diversify.

This is one of those times where you’ll thank me for that advice or wish you had listened!

But if you think I am a doomsayer and choose to live in a fantasy world where house prices never go down, then I hope you have the income to support it.