Australia’s financial regulator has lifted its restriction on banks’ ability to issue interest-only loans, in a move that will likely support house prices.

Data revealed last week that property price declines in Sydney and Melbourne were no longer confined to expensive dwellings, but had spread to middle and lower segments of the market in recent months.

The Australian Prudential Regulation Authority (Apra) announced on Wednesday that it would be removing its restriction on interest-only residential mortgage lending for banks that have improved their lending standards.

The restriction will be lifted on 1 January, 2019.

It follows Apra’s decision in April to remove its 10% restriction on “investor loan” growth for banks that had improved the quality of their investor lending in recent years.

Apra said it would now be removing its restriction on “interest-only” lending too, but only for banks that had already sufficiently reduced the amount of investor loans they had been writing. For other banks, the interest-only restriction will be lifted once they have met Apra’s requirement to reduce their investor loans sufficiently.

The restriction had limited the flow of new interest-only lending to 30% of total new residential mortgage lending written by a bank.

Both restrictions – on investor loans, and on interest-only loans – had been introduced by Apra amid concerns about heightened risks surrounding rising housing prices, high and rising household indebtedness, subdued household income growth, historically low interest rates and strong competitive pressures.

But Wayne Byres, Apra’s chairman, said the restrictions on investor loans and interest-only loans had now served their purpose.

“The benchmark on interest-only lending was put in place as a temporary measure in 2017, with the aim of reducing the level of interest-only lending and improving the quality of mortgage portfolios,” Byres said on Wednesday.

“Since the introduction of the benchmark, the proportion of new interest-only lending has halved, and interest-only lending at high loan-to-valuation ratios (LVR) has also declined markedly.

“In summary, as with the benchmark on investor loan growth, this measure has served its purpose.”

Byres said he still viewed interest-only mortgages, and in particular owner-occupied interest-only lending, as a higher risk form of lending, so Australia’s banks must maintain “prudent” internal risk limits on interest-only lending.

He said a re-acceleration in interest-only lending at an industry-wide level would raise “systemic concerns” for Apra, and the regulator would be willing to apply regulatory brakes again if necessary.

“In such a scenario, Apra would consider the need to apply industry-wide measures in response,” he said.

JP Morgan economist Sally Auld said Apra’s decision was unlikely to trigger a quick acceleration in interest-only lending.

She said interest-only loans were significantly repriced after the restriction was introduced in 2017, so the decision will likely result in some reduction in rates for interest-only loans. But with lenders yet to feel the full impact of the banking royal commission, house prices still falling, and regulators focused on loan-to-income ratios and serviceability criteria, it was hard to see much changing in the supply of credit in the near term, “despite the Reserve Bank’s desire”.

Earlier this month, the Reserve Bank warned Australia’s biggest banks not to restrict their lending too much during the current housing downturn, cautioning if borrowers were scared away it would negatively affect the economy.

The Property Council of Australia, and the Australian Banking Association (ABA), have welcomed Apra’s decision.

“This is a sensible step by Apra that supports the strength and stability of our financial system, which is the bedrock of the property industry,” said Ken Morrison, the chief executive of the Property Council.

“At a time when some of our largest residential property markets are cooling, Apra’s announcement provides welcome certainty and direction,” he said.

The chief executive of the ABA, Anna Bligh, said the decision would allow all banks to offer more choice for customers, leading to an increase in competition across the industry.

“Apra’s announcement today shows that banks have adjusted lending to respond to concerns around an oversupply of interest-only loans, illustrating a prudential system where both banks and regulators can quickly and effectively respond to a changing environment,” she said.

“While banks will continue to lend prudently, today’s decision will mean all banks can offer more choice for customers who are looking to buy a house or apartment.”

Bureau of Statistics figures show property prices in Australia’s eight capital cities fell 1.5% on average in the September quarter, marking nine consecutive months of price declines.

The mean price of Australia’s residential dwellings is now $675,000, down from a peak of $697,100 at the end of 2017. Despite the decrease, the mean price is still $188,600 higher than it was six years ago.

The nationwide decline in property prices is being driven by large falls in Australia’s two biggest property markets: Sydney and Melbourne.

The average decline is masking very different property market conditions around the country. Over the past 12 months, residential property indices have fallen in Sydney (-4.4%), Darwin (-4.4%), Melbourne (-1.5%), and Perth (-0.5%), but they have risen in Hobart (13%), Canberra (3.7%), Adelaide (2%) and Brisbane (1.7%).