APRA's move to scrap the limit on interest-only mortgage lending may have been forced by the banks' overreaction to regulatory attention on lending standards.
The Australian Prudential Regulation Authority on Wednesday said it would remove its temporary cap on interest-only residential loans, on the grounds that the measure had successfully curbed higher-risk lending practices.
APRA will remove the cap on January 1 after saying it "led to a marked reduction in the proportion of new interest-only lending, which is now significantly below the 30 per cent threshold".
But Housing Industry Association principal economist Tim Reardon said homebuyers had endured significant borrowing constraints because banks had gone too far.
"The credit squeeze is happening at the behest of the banks' own lending practices, which have been tightened above and beyond APRA's requirements," Mr Reardon said.
"APRA's announcement sends an important message about the overall health and stability of the mortgage market which should be heeded by policy makers and lenders alike."
APRA introduced the limit in March 2017 amid concerns about a housing bubble.
Residential property prices in Australian major cities have since fallen the most in three decades, with banks slowing approvals and tightening standards against the backdrop of the royal commission.
"APRA's lending benchmarks on investor and interest-only lending were always intended to be temporary," APRA chairman Wayne Byres said.
"Both have now served their purpose of moderating higher risk lending and supporting a gradual strengthening of lending standards across the industry over a number of years."
At their peak, interest-only loans accounted for 40 per cent of all mortgages.
But the loans carry more risks than common principal and payment mortgages, leading regulators to tighten standards on such lending.
As a result, banks have raised rates on interest-only loans, prompting concerns about heightened pressure on borrowers.
Mr Byres said most lenders have given assurances that they have tightened their lending standards and that the authority would review their internal risk controls in 2019.
The Property Council's Ken Morrison said the announcement provided "welcome certainty and direction" at a time when some of the largest residential property markets were cooling.
The ANZ/Property Council industry confidence survey for the December 2018 quarter found expectations around debt finance availability over the next 12 months had fallen to record low levels.
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