As the balance on the average Aussie’s home loan continues to grow, consumer watchdogs have warned against “toxic” interest-only loans for home-owners.

Despite record low interest rates and efforts by regulators to tighten lending standards of local banks, the average mortgage debt of local home borrowers rose to $239,000 at the end of September.

That represents a rise of $7000 on the average home loan balance of $232,000 recorded at the end of September last year, according to the latest data published by the Australian Prudential Regulation Authority.

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But in the last 18 months a new trend has emerged in the home loan market – more people buying a house to live in are taking out interest-only mortgages.

These loans, which are the fastest growing category of home lending, mean borrowers only need to pay the interest component of the loan at the end of each month. Repayments to the principal are deferred.

The idea behind this comes from investors. They aim to borrow, and hope the value of the property will increase enough to pay off the principal in three to five years’ time – also delivering them a capital gain. As a kicker there are also tax benefits for taking these types of loans, but only for investors.

CHOICE has cautioned home owners saying interest only loans can be a “high-risk borrowing option”.

“While some consumers are attracted to these products when interest rates are low and various asset classes are in a growth phase, when markets contract you can be left with a lot of debt and not much to show for it,” head of media Tom Godfrey said.

“These loans are particularly toxic in the housing market if a significant correction occurs, as happened in 2007-08.”

He warned that when interest rates rise, as is predicted by economists to occur next year, home owners could find themselves struggling with repayments with little equity to work with.

“As a rule, you want to pay off a loan as quickly as possible – principal and interest. Even with tax benefits, if your circumstances change you can find yourself moving from interest only to debt only.”

The average balance on interest-only mortgages ballooned to $308,000 at the end of September.

This fast-growing category of home lending now accounts for more than one third of Australia’s $1.3 trillion home loan market.

Why worry?

Credit ratings agency Moody’s highlighted the risks associated with this interest-only trend in a report published last month.

Moody’s senior analyst Alena Chen observed that interest-only loans had the potential to trigger greater financial stress among home borrowers if interest rates were to rise.

“Over the past year, a notable rise has occurred in the amount of interest-only loans in Australia and owner-occupiers – people who buy a home to live in, as opposed to investors who buy to rent out – are accounting for a growing share of these loans,” Ms Chen stated in the report.

“There are concerns that many of the owner-occupiers taking out these loans – which are generally larger than the traditional principal and interest loans – would consequently find it difficult to service them if interest rates start to rise.”

Ms Chen also observed that interest-only loans were more risky for lenders and borrowers compared to mortgages where repayment of principal and interest was required from day one of the loan contract.

The main reason why interest-only loans are more risky is that they usually convert after five years to a standard repayment schedule under which the principal has to be reduced.

The problem for owner-occupiers is that they are not eligible for the tax deductions enjoyed by investors who borrow for a second property.

The primary effects on owner-occupiers are to delay the repayment of principal and magnify interest costs.

If rates were to rise …

Owner-occupiers should consider the risks of not building equity in their home before taking out an interest-only loan.

Such loans can make borrowers more vulnerable to sustained falls in house prices, interest rate hikes or both.

The ultimate cost of a home loan to an owner-occupier essentially boils down to how quickly the debt can be cleared.

Even if that might take 20 years, home buyers who begin reducing the principal from day one of their loan are more likely to minimise total interest charges than interest-only borrowers.

With equity in their home, borrowers with a conventional loan might also be better placed to refinance to a mortgage on better terms when interest rates begin to rise.

Borrowers with no equity in the house they live in have less flexibility and are probably destined to pay more for longer.