Moody's cautions on interest only loans

The size discrepancy between the average interest only loan and the average principal and interest loan is a key risk factor for investors in mortgage backed bonds to consider, Moody's Investors Service said yesterday.

"In our existing RMBS portfolio, the average loan size of owner-occupier IO loans is A$289,800, compared with $187,500 for PI loans," Moody's wrote in its October bulletin to clients.

"In addition, the current loan-to-value ratio of owner-occupier IO loans is 2.1 per cent higher than PI loans."

Moody's and other analysts have correlated demand for interest only loans with rising house prices in Australia, while the Reserve Bank of Australia has warned that lending practices such as IO loans and rising LVRs indicated risks to banks were increasing.

Nationally, house prices increased by 9.3 per cent over the year ended September 2014, while in Sydney, the city with the highest growth, prices rose by 14.3 per cent, Moody's said.

Interest only loans are also paid off at a slower rate, evidenced by the lower levels of pre-payments for IO loans (5.1 per cent in advance of their scheduled payment balance), when compared with principal and interest loans (6.5 per cent), the ratings agency noted.