ING Direct has now joined the large and growing group of lenders tightening up their requirements for home buyers keen on an interest-only home loan.

It has stopped interest-only repayments on new applications for owner-occupied fixed-rate home loans.

And it is in good company, with major and minor banks making significant changes to their offering of this type of mortgage product.

Much of this is due to increased regulatory scrutiny during the past few months, with the banking regulator – the Australian Prudential Regulation Authority (APRA) – cracking down on this type of lending.

Since March, APRA has put a limit on interest-only lending to 30 per cent of total new residential mortgage lending, put restrictions on interest-only lending on loan to value ratios (LVRs) above 80 per cent, and asked for strong scrutiny of interest-only loans at an LVR above 90 per cent.

A recent survey of a panel of economists by comparison website Finder found more than half thought those switching from interest-only to principal and interest may face difficulties refinancing.

A loan to value ratio is the proportion of the loan being borrowed compared to the deposit, so an LVR of 90 per cent is when a borrower has a 10 per cent deposit.

What is an interest-only loan?

An interest-only loan in the residential housing context is a type of mortgage where the home owner makes repayments on only the interest portion of the loan.

That is, they don’t pay down the “principal” component of the loan – the part that actually pays off what the asset is worth.

By comparison, in principal-and-interest loans the borrower repays both of these components. This is usually the more common type of loan, particularly among owner-occupiers, and it means that you are continually paying down the actual worth of the home.

Interest-only loans have typically been seen as more of an investment product, but this isn’t always the case.

Why would someone want an interest-only loan?

An interest-only loan has much lower repayments than a standard loan, and this can be attractive for many reasons.

It doesn’t cost the property owner as much to pay their mortgage – making it easier to hold.

For investors, this means they might have a higher cash flow – or be less out of pocket. And for home owners, this can be a way to free up funds for other ventures.

The interest portion on an investment loan is often tax deductible while the principal portion is not.

Those who have plans to sell the home in the short-to-medium term and are anticipating substantial capital gains could find this attractive.

They could also be useful for those facing hardship, Aussie chief executive James Symond said.

“They serve a purpose on a short-term basis for first home buyers who may need some relief early on in the life of the mortgage after purchasing a property and for those owners who only want to hold a property for only a few years.

“Interest-only loans did rise in recent years at Aussie and the arrears and default rates remain negligible.”

Lately there has been a trend away from this type of product, he said.

Why is it seen as risky?

In March 2015, Aussie Home Loans chairman “Aussie John” Symond called for a ban on interest-only loans for home owners.

He warned: “If you can’t afford to pay interest and principal, then you shouldn’t get a loan.”

And in March 2016, APRA chairman Wayne Byres said the higher proportion of interest-only lending was indicative of a “higher-risk profile” it would be monitoring. So what is this risk?

Without paying down the principal, the only way an owner can accrue equity in their home is to hope for rising prices, LF Economics co-founder Philip Soos said.

When an interest-only loan is given to someone who would otherwise not be able to afford a loan, there is the risk that when the loan reverts to being principal and interest – typically after a stipulated number of years – they’ll be unable to afford the repayments.

This can “easily cause payments to jump by 20 per cent”, Mr Soos said. If interest rates increased, which would affect all borrowers on variable rate home loans, this could climb even higher.

“Basically, interest-only loans are predicated on prices always rising and not falling,” he said.

And while home loans can sometimes be refinanced back to interest only, personal circumstances can change and the property market could fall in value.

There are also concerns that interest-only lending encourages people to borrow more than they would otherwise – particularly when investing, Uno Home Loans chief executive Vincent Turner said.

“In short I’d say that they are, by definition, only applicable when you expect to buy and sell property for a profit with some certainty,” Mr Turner said.

“Someone who is paying interest only is not intending to pay off the loan through normal repayments, but through capital appreciation only. Which adds up in a rising market but not so much in a sideways or dropping market. That is also a risk but to be fair that impacts investors and home owners alike.”

Interest-only borrowers, by definition, don’t pay down the principal and so the home owner is not building a “buffer” into their mortgage. If prices fell the home owner still has to pay off the entire property value and may hold an asset worth less than the loan.

A recent survey of a panel of economists by comparison website Finder found more than half thought those switching from interest-only to principal and interest may face difficulties refinancing.

The panel also anticipated interest rates’ next move would be up – which would leave interest-only borrowers more vulnerable than other mortgage holders because the interest portion would rise more.

What has been changing?

It’s getting tougher for those who want to get an interest-only loan.

ME Bank, Commonwealth Bank of Australia, Westpac, AMP, Citigroup and, now, ING Direct have been among those to make changes to the way they offer interest-only loans.

Some have banned these loans above a certain LVR, and others have significantly increased the interest rates charged on these products.

As Compass Economics chief economist Hans Kunnen explains, banks are now “reining it in”.

Under these changes, some borrowers might find themselves ineligible for an interest-only loan under the changes and may need to “cash out” and sell the property, he said.

Starr Partners chief executive Doug Driscoll said it wasn’t “prudent of banks at all to have lent on so many interest-only loans because the worry is that we are a nation riddled with debt”.

“The market has been massively out of kilter for some time now; it’s an overheated investor market. I’m very pleased with APRA’s recent crackdown because, at the end of the day, people need to be in a position to service their loans,” he said.