The big switch is on in the mortgage market.

Key points: In past six months $36bn of mortgages switched from interest-only to principal and interest loans

In past six months $36bn of mortgages switched from interest-only to principal and interest loans The switch adds up to an extra 50 per cent to loan repayments

The switch adds up to an extra 50 per cent to loan repayments APRA likely to tighten lending rules further, targeting loans to home buyers with little surplus cash flow

In just the past six months the amount of interest-only (IO) loans held by the banks have dropped by around $36 billion, according the Australian Prudential Regulation Authority.

APRA can feel pretty chuffed with the result. It is exactly what it wanted in its push to de-risk banks' balance sheet by quelling the speculative bravado of investors.

But there are obvious side effects in targeting interest-only loans.

They are the instrument of choice for not only investors biding their time in the tax haven provided by negative gearing to make a windfall gain on capital appreciation.

They are also used by maxed-out borrowers repaying as little as possible, hoping for a bit of financial headroom if wages pick up.

Unfortunately wages show no sign of picking up.

As the 19th century Prussian Field Marshall Helmuth Graf von Moltke once noted, "No battle plan survives first contact with the enemy", and APRA's insurgency has the IO brigade scampering in retreat.

It is a retreat that will further cripple the spending power of cash-strapped households and has profound implications for the Australian economy, according to the big Swiss investment bank, UBS.

Repayments set to soar

Already household wealth built up by years of rising house prices shows signs of peaking as the market cools.

At the same time savings are being eroded just to pay for the essentials — such as utility bills and mortgages — leaving many households at a financial breaking point.

So far the switch from IO to principal and interest (P&I) has been small, but momentum is building.

"We estimate that the additional household cash-flow hit from switching to P&I was only around $1-$2 billion, or just 0.1-0.2 per cent of total household sector income," UBS chief economist George Tharanou said.

However, Mr Tharanou said there is likely to be a notable and increasingly negative impact over time.

"Those individuals switching from IO to P&I do face a material 'shock' with scheduled mortgage repayments jumping — effectively overnight — by 35-to-50 per cent," he said.

For those with little or no headroom at the moment, a 50 per cent jump in repayments may simply be impossible to finance.

House prices likely to cool as stressed buyers sell

On figures put together by the UBS banking analysts, the potential expiry of IO loans in coming years will surge up to more than $100 billion in the 2018 financial year.

Assuming the typical five-year maturity and no rollover to another IO term, almost $140 billion of IO loans will have wound up by 2019, a figure which jumps to $153 billion in 2020.

A survey by UBS of borrowers found that the majority under financial stress from higher interest rates would cut consumption, while a significant share would sell their property.

But that might be just the start, as "Phase 3" of APRA's macroprudential tightening may well start next year.

Phase 1 put a speed limit on the Big Four banks investment lending, capping growth at below 10 per cent a year.

Earlier this year Phase 2 was enforced limiting IO loans to 30 per cent of new residential mortgage loans.

Before that tightening, IO loans accounted for up to 40 per cent of the banks' mortgage portfolios, which APRA noted at the time was "quite high" by international and historical standards.

Phase 3 is expected to zero-in on the net income surplus (NIS) — or a lender's assessment of surplus income borrowers have left over after living expenses, debt repayments as well as some "pocket money" — as well as loan-to-income valuations.

APRA's concern is that many new borrowers have very little surplus income to deal with souring conditions, including higher interest rate charges.

The APRA survey found almost 20 per cent of new loans were made to borrowers with a NIS of less than $200 a month, while 3 per cent of lending had nothing left over, or in fact had a "negative" NIS.

"For now, household cash flow in 2017 has been crunched down to a record low of only around 1.5 per cent year-on-year," Mr Tharanou said.

"In addition to weak wages income, there has also been significant drags on household cash flow from the combination of higher taxes — mainly via 'bracket creep' of higher average tax rates — as well as a surge in both utilities and petrol, almost entirely driven by higher prices rather than volumes."

Inappropriate RBA move risks 'housing collapse'

Mr Tharanou noted that despite households struggling to pay their bills, no additional RBA rate cuts meant a smaller fall in interest payments compared with prior years.

The overall picture is fairly bleak with a collapsing saving rate unlikely to fund household consumption much longer.

"So unless there is a surprisingly strong surge in wages, or a further drop in inflation, then real consumer spending will likely slow ahead," Mr Tharanou argued.

"But we continue to worry that if the RBA hikes too much and, or too early, they risk turning an orderly housing correction/soft landing — as appears to be unfolding at the moment — into a housing collapse."

And that would be a whole step up in the level of household pain.

Unemployment would most probably rise, as would bad debts and perhaps foreclosures.

As Mr Tharanou noted that could potentially lead to "a self-reinforcing negative feedback loop between asset prices and the real economy".

And that would not be pretty.