I have just come across the news today (05 June 2010) that ING Direct is going to offer no fixed term interest only home loans. And this should be great news for all those who cannot afford to by their own home. Or maybe it is not such a great news after all.

Another article has just revealed that US hedge funds have been offloading their Australian bank shares because they think the Australian property market will take a dive. Of course, the RBA tries to convince us that there is no property bubble, but if you consider the following chart that shows the REAL house price index, you will wonder what the RBA is talking about.

The normal median house price would be 3 times the average yearly income.

Now consider that the average annual income in Australia is about $60,000, so an average house should cost around 180,000, no more. However, you cannot buy anything for this amount. The average house prices are listed here (these are 2009 figures, the 2010 figures would be higher for most cities). So in Sydney the average house price is close to $600,000. This is 10 times the average income (over there the average income may be somewhat higher though)! In Brisbane it is about $450,000, which is 7.5 times the average income! The Gold Coast, where I live, is a touch cheaper, maybe around 7 times the annual income (am not sure about the exact figures). This means there is a pretty big bubble at a time when the world economy is about to enter round two of the financial crisis (hasn’t anyone told you there is no economic recovery, but great depression is in the making?).

So, here we go,  the housing bubble is about to deflate, the banks know it because their stocks are being hammered by hedge funds, but most people still don’t know it because they trust the RBA. Now, ING comes up with a brilliant idea. You will never have to pay principal on the home loan, only the interest, and there is no fixed term. Wow!

This would be the kind of loan investors always dream about, but this loan is only great in boom times. Say, you bought a house 20 years ago for $50,000 and today it is worth $450,000. The principal is still the same, but inflation almost wiped it out. The equity in your home is now $400,000 and you only paid interest after $50,000 for the past 20 years, say, for easy calculation, if the interest is 10% each year, you pay $5,000 a year for 20 years. Thus your interest payment comes to $100,000. You are clearly a winner: 450,000 – 100,000 – 50,000 = $300,000!

However, if you buy the same house today for $450,000 and you only pay interest (say, for easy calculation make it 10% again), you pay $45,000 every year you have the loan. Now, what if house prices don’t go up, but plunge, like they did and do elsewhere? Suppose, in 10 years time your home is only worth $150,000, which is a possibility in a great depression, and you paid out $450,000 in interest (providing you had a job throughout this time). Well, the deal now doesn’t look so good after all. You paid the bank $450,000 in the interest payment, but you still owe the bank the principal, which is another $450,000. That is $900,000! And your home is only worth $150,000  – a $750,000 loss!!! This is after paying the interest for 10 years, but you have not reduced the principal by a single dollar, so in another 10 years you will pay another $450,000 in interest. And the price of your home may not recover for another 40 years like in the Great Depression of the 1930’s! If the price of your home drops, you cannot sell your home. You can only default on the loan. In Australia you cannot simply walk away like in part of the US, they come after you, so defaulting is not much fun.

Do you still think buying on the top of the bubble is such a good idea?

We have not talked about what happens if you default on the loan. The bank will have to sell your home in a depressed market and write off the loss. The bank with the most mortgages will suffer the greatest losses. One may wonder that it wasn’t such a great idea from WestPac to carve out the biggest slice of the mortgage market. They might be heading to the biggest fall.

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