Who would want an interest-only loan anyway? That is the blunt question posed by Macquarie Bank analysts in the wake of another round of rate hikes from the big lenders.

Key points: Interest-only loans currently growing at 40pc a year, APRA has demanded that slow to 30pc growth

Interest-only loans currently growing at 40pc a year, APRA has demanded that slow to 30pc growth Interest only loans from the big banks now up to 60 basis points more expensive than principal and interest rates

Interest only loans from the big banks now up to 60 basis points more expensive than principal and interest rates Over 10 years, a $500,000 IO loan would cost $12,000 more than a P&I loan

Macquarie's bank analysts have argued that, with interest-only (IO) loans now between 0.45 and 0.6 percentage points more expensive than principal and interest (P&I) loans, it is economically rational for borrowers to switch.

Using a 0.5 percentage point differential, Macquarie found that a bank customer in the top tax bracket with a $500,000 loan would be $6,000 better off after five years, and $12,000 better off after 10 years switching to P&I.

"In our view, this will result in more customers who can afford P&I repayments switching loans and make new customers more likely to consider a P&I loan at origination, which are clearly less profitable for banks," Macquarie said.

"Our analysis suggests that this is also applicable for investors, despite negative gearing benefits associated with IO product."

The argument for interest-only has always been the flexibility they provide, with an offset account to allow investors to borrow more and build up a property portfolio.

Macquarie values that flexibility at around 0.1 to 0.2 percentage points for investors, but now found that benefit has largely been eroded by the banks' latest moves.

P&I and IO cashflows for $500,000 investors

Year 1 Year 2 Year 3 Year 5 Year 10 Remaining balance (IO scenario) $500,000 $500,000 $500,000 $500,000 $500,000 Net financial position (IO scenario) -$505,250 -$510,402 -$515,453 -$525,251 -$547,888 Remaining balance (P&I scenario) $491,085 481,813 $472,171 $451,713 $393,965 Net financial position (P&I scenario) -$504,209 -$508,292 -$512,243 -$519,729 -$535,730 Net benefit from P&I vs IO $1,041 $2,110 $3,210 $5,522 $12,158

Calculations based on a 0.5pc differential and includes benefits from negative gearing, rental income and other property related expenses. Source: Macquarie Research

Spurred on by investors chasing rising property prices, IO loans have gained considerable momentum and now account for around 40 per cent of new mortgages and about half the total mortgages held by the big banks.

The popularity of interest-only loans has grown to the point where they now represent between 40 and 55 per cent of the big banks' mortgage portfolios. ( Source: Macquarie Research )

Sydney-based mortgage broker Bruce Carr from Loanscape said, given the banks only repriced loans over the past couple of weeks, it is a bit early to say whether a big switch is on, but movement is certainly likely.

"I have one client who has shifted four accounts to P&I and was happy to pay the higher cash flow rather than the higher interest rates," Mr Carr said.

"The banks have been making it easier to switch, waiving the usual fees."

Macquarie's view is that, given the interest rate differential and regulatory limits placed on the banks to keep IO loan growth to 30 per cent, customers who are not overstretched will move to P&I repayments fairly quickly.

"Customers who are not able to switch due to an inability to absorb higher payments are likely to get stranded in the more expensive IO product, ultimately giving rise to some adverse selection within banks' portfolios," Macquarie said.

Bank earnings to be eroded by the switch

Banks have enjoyed the benefit of IO loans not amortising, so they provide solid support to balance sheets at a relatively low cost.

This is one reason why they have been happy to expand this part of their loan portfolio.

P&I loans are also a lower margin business.

"We estimate that a 25 per cent shift from IO to P&I would result in 1.3 to 2.5 per cent reduction in banks' earnings from lower margins, " Macquarie calculated.

"We believe that this trend will result in a headwind to margins, partly offsetting the benefits of recent IO repricing and in the longer term greater amortisation of loans, supporting our subdued mortgage volume growth forecasts of around 2 per cent."

Impact on bank earnings from 25pc of IO loans switching to P&I

Bank Earnings impact Annual drag on growth ANZ 1.3pc 0.26pc CBA 1.6pc 0.27pc NAB 1.3pc 0.22pc Westpac 2.5pc 0.34pc

Source: Company data, Macquarie Research

First home buyers still out in the cold

Mr Carr said the crackdown on investor lending is already starting to bite.

"Investors have stopped looking, but there is not a lot of opportunity for first home buyers to pick up the slack," he said.

"They have stood on the sidelines with too small a deposit for years while prices have kept rising."

"Now they have got a bit of government assistance and investor interest is cooling, they still have to borrow 40 to 50 per cent more."

