One in three don't understand their interest-only loans, says UBS

A third of customers with interest-only mortgages may not properly understand the type of loan they have taken out, which could put many in "substantial" stress when the time comes to pay their debt, UBS analysts warn.

Amid a regulatory crackdown on interest-only loans, a new report by analysts led by Jonathan Mott highlights the potential for repayment difficulties with this type of mortgage.

Typically, an interest-only loan will allow a customer to only pay interest for the first five years. After that, they must start also paying principal, which raises their monthly payments substantially - or attempt to refinance.

However, the UBS analysts believe there is a real risk many consumers do not realise their mortgage payments will rise in this manner.

Their finding is based on a recent survey conducted by the investment bank, which found only 23.9 per cent of 907 respondents had an interest-only loan, compared with economy-wide figures that show 35.3 per cent of loans are interest-only.

Mr Mott said he initially suspected the survey sample had an error, but now believed a "more plausible" reason was that interest-only customers did not properly understand their loan.

In the clouds: One in three borrowers seem to be clueless about their interest-only loans. Photo: Bill Oxford

In the clouds: One in three borrowers seem to be clueless about their interest-only loans. Photo: Bill Oxford

"We are concerned that it is likely that approximately one third of borrowers who have taken out an interest-only mortgage have little understanding of the product or that their repayments will jump by between 30 and 60 per cent at the end of the interest-only period (depending on the residual term)," he said.

"While these loans are well secured, we believe many borrowers may face substantial stress as interest rates rise or when they revert to principal and interest."

Mr Mott conceded it may seem "far fetched" to suggest a third of customers didn't understand what they had signed up for, but said it needed to be seen in context of poor financial literacy.

He cited a 2014 Standard & Poor's report that said 64 per cent of Australian adults were financially literate - implying 36 per cent were not. Mr Mott also quoted a 2015 survey from ME Bank, saying it showed 38 per cent had "no understanding" of interest-only repayments.

Managing director of mortgage broker Homeloanexperts.com, Otto Dargan, agreed many customers may not fully understand the risks and extra costs of interest-only borrowing.

"Customers are not astute when it comes to interest-only. It's really only very experienced brokers and bankers who understand the damage of interest-only loans," Mr Dargan said.

Analysts are focusing on the risks of interest-only loans after the regulator this year capped at 30 per cent the proportion of new lending banks could do on an interest-only basis, in an attempt to dampen risks in the housing market. These rules may make it harder for customers seeking to refinance after an interest-only period ends.

The survey data being used by Mr Mott also found only 67 per cent of respondents had been "completely accurate" in their mortgage application, leading Mr Mott to last month suggest $500 billion loans were inaccurate or "liar loans."

Financial regulators have also repeatedly raised the alarm about banks' practices in interest-only lending - a market worth about $460 billion.

2015 report by the Australian Securities and Investments Commission found "troubling" flaws in banks' credit standards in interest-only lending, saying in many cases lenders over-estimated how much time customers had to repay the bank once their interest-only period ended.