With 1.46 million outstanding interest-only mortgages, even if a relatively small proportion of borrowers struggle – say 10 or 15 per cent – that may imply as many as 220,000 households could soon be in strife.

The warning comes just two days after Reserve Bank governor Philip Lowe put Australian borrowers on notice that a likely official interest rate hike will come as a shock to many households given they haven't seen one in seven years.

Boom in lending

The reset risk comes as a direct consequence of a boom in lending that peaked in 2014, led by property investors who sought to supercharge their borrowing power by taking out loans in which the principle typically isn't repaid for the first five years.

Such loans have been targeted by regulators in two waves of macroprudential restraints – in 2014 and 2017 – amid concerns they were stoking dangerous house price bubbles in Sydney and Melbourne.

As a result, there has been a collapse in the issuance of interest-only loans to around 30 per cent of borrowing by investors from 60 per cent four years ago, a key reason for weaker property prices over the past six to nine months.

But the legacy loans issued during the frenzy are now starting to reach their trigger points. The Reserve Bank estimates around $120 billion in loans will convert to traditional principal and interest loans every year between 2018 and 2021.


Despite the large increases in repayments when such loans reset – officials estimate they will leap by between 30 per cent and 40 per cent – the Reserve Bank believes most borrowers "should be able to afford the step-up in mortgage repayments" because they have accumulated substantial prepayments.

"And the serviceability assessments used to write IO loans incorporate a range of buffers," it said in the latest Financial Stability Review, published on Friday. "Moreover, these buffers have increased in recent years."

It also said that some borrowers may be able to delay or reduce the step-up in repayments. "The share of borrowers who cannot afford higher P & I repayments and are not eligible to alleviate their situation by refinancing is thought to be small.

"In addition, borrowers who are in this situation as a result of past poor lending practices may be eligible for remediation from lenders."

Strengthening of lending standards

The warnings about loan resets came as the central bank said that the resilience and overall financial performance of Australian banks has "continued to improve".

The Reserve Bank noted that property prices had declined in Sydney but pointed out that falls in value had been observed at the higher end of the market.


"Regulatory measures and broader strengthening of lending standards have contributed to an improvement in the risk profile of new housing lending and the resilience of household balance sheets," they said. "They have also contributed to the recent moderation in housing market conditions."

The bank also appears to have downgraded concerns issued in more recent stability reviews about a glut of apartments.

"The potential risks posed by the large pipeline of apartment construction in Sydney and pockets of inner-city Melbourne and Brisbane have not materialised in a significant manner, at least to date.

"In Melbourne and Brisbane, the flow of new additions has peaked and, so far, been absorbed with little disruption to apartment markets, with vacancy rates steady or declining, rents steady or rising, and apartment prices generally only falling modestly."

RBA governor Phillip Lowe. The banks says the mortgage resets are an "area of potential concern". TREVOR COLLENS

Those fears have been replaced with a new warning that commercial property prices "remain an area to watch".

Non-residential commercial property prices in Sydney and Melbourne have risen further, with yields falling, in part reflecting ongoing "search for yield" activity.


At a global level, officials have ramped up their warnings about the likely impact of rising interest rates on "elevated" prices for stocks, bonds and other assets.

Financial shock

"Current asset pricing suggests that investors see little chance of adverse outcomes and consequently a detrimental shock could lead to a disruptive and lasting correction in a broad range of markets," they said.

"This could be triggered by a sharp rise in interest rates in the absence of stronger economic growth arising from, for instance, a jump in realised or expected inflation or a change in investors' appetite."

It said the main risk to Australian banks from higher interest rates would most likely be through rising numbers of bad loans among mortgages and business borrowers.

It said investors, in responding to low interest rates, had engaged in several strategies to increase returns that it believed would "increase the response to or amplify a financial shock".

They include a shift into lower-rated assets to boost returns, a shift into relatively illiquid assets, a move into areas beyond their traditional area of expertise, an increase in exposures that have longer maturities and an increase in leverage.

"Given the multitude of changes in institutional structures, investors' asset holdings and market dynamics, it remains uncertain how different classes of investors will be affected by, and respond to, asset price falls."