Finance Market Update - 17 08 18
Updated: Aug 19, 2018
In this finance market update we discuss how ‘Interest Only’ loans could impact property prices, why borrowers with this loan type end up paying back more than others and what options there are for borrowers facing a “rollover” from ‘Interest Only’ to ‘Principal & Interest’ repayments.
Interest Only Loans and Property Prices
For the last few years the go to loan type for many borrowers has been ‘Interest Only’ (“IO”). This is because the repayments are lower than a mortgage with ‘Principal & Interest’ (“P&I”) repayments, making it more affordable.
Lenders were also very keen to give out IO loans as they did not have any government restrictions, made more profit on IO loans (more on that later) and found many able and willing borrowers.
Times have changed. The ‘Australian Prudential Regulation Authority’ (“APRA” who is responsible for regulating the banks) clamped down on IO lending by banks. This means that big banks had to and still are cutting back lending IO and need to ‘force’ the “rollover” from IO to P&I repayments.
This is worrying for many borrowers, particularly investors, who have been relying on the lower IO repayments to be paid for largely by the rent from an investment property.
It also means that as an average monthly IO repayments could jump up around 30-40%. That is like a monthly IO repayment of $2,500 going up to $3,250 which is a big hit to cash flow. Especially when living costs are going up, and wages are flat.
There are serious ramifications in this for the property market.
Firstly, the RBA estimates there is ~$360 billion worth of interest-only loans will roll over to P&I repayments over the next three years. That is a lot of borrowers who are about to see an uptick in repayments.
Secondly, if people can’t afford the uptick in repayments then they may sell their property.
Lastly, if people really can’t afford the repayments or would have to sell the property at a loss (refer the previous update with ‘Negative Equity’) then they might default on the loan and the bank will seize the property and sell it off.
All these scenarios could mean more properties coming to market and to be sold at the same time which would further pushing down prices.
Combine that with less credit available which lowers buyers’ ability to buy, and we could see a fundamental decline in property value.
If banks’ profits are under threat they would likely further cut back lending, and as we have discussed before, less lending means lower credit in the market which means lower purchasing power of property and lower property prices.
As we continue to see credit “tightening” (which means harder to get, or less available) the scenario of a flood of properties coming to market because the IO period has expired could really put heavy downward pressure on property prices.
Why borrowers repay more on Interest Only loans
Borrowers with IO loans end up repaying more than if they were on P&I repayments.
Why? After the IO period ends they still owe the full debt and have to pay it off within the original mortgage term, which is often 30 years.
For example: If a borrower has a 30-year mortgage term with a 3-year IO period they will end up paying back 30 years’ worth of principal and interest in 27 years, on top of the first 3 years’ worth of IO repayments. This is because the first 3-year IO term is just servicing the debt, not paying down the debt itself.
Assuming no extra repayments are made this means they end up paying back around 3 years more worth of interest. This extra interest paid by the borrower also makes IO loans a very lucrative loan type for the banks and lenders.
Numbers Example: You have a $700,000 loan on a 30-year term with a 3-year IO period to start. During the IO period of 3 years, say repayments are $2,500. The first 3 years of repayments are $90,000 in total ($2,500 x 36 months). None of that pays down the $700,000 debt. So, when year 4 starts with P&I repayments you still have to pay it down by the 30-year term, which means the total $700,000 + interest is paid down over 27 years (30-year term minus 3-year IO period). So the $90,000 already repaid is an additional cost than if you were repaying P&I from the start.
You effectively have less time to repay the total loan over 27 years which also means your P&I repayments from year 4 are higher than they would have been than if you started with P&I repayments from the start.
If you want to discuss this in more detail, please contact Skyward Financial.
What options do Interest Only borrowers have?
Depending on the unique circumstances there are always options.
For borrowers currently with an IO loan that is due to roll over to P&I soon there are a few strategies available, we are currently working with borrowers on these and able to help you as well.
You have options with other lenders to refinance your current loan with them and keep IO repayments.
We are seeing ‘second tier lenders’ open to this kind of business, but borrowers must be aware of the costs associated with not paying down principal.
When the IO period ends its called ‘rolling over’ to P&I. If you can afford the higher P&I repayments it could be worthwhile paying them.
Your current lender might be willing to extend the IO term. While this is difficult to get them to agree to it could offer time to rethink the long-term mortgage strategy, if you have one.
At Skyward Financial we talk to clients about having a ‘Mortgage Strategy’
Having a mortgage is a big commitment, so it pays to have strategy to pay it down and manage it.
This includes planning ahead and thinking about how to manage and repay your mortgage. For clients with IO loans we have talked about having an offset account and making additional repayments where possible. This can mean after the IO term there is a lump sum available, which can either be used to alleviate the cash flow change of higher P&I repayments by using those funds, or when it rolls over the total interest amount repaid will be lower due to the funds in the offset account.
If you or someone you know is facing an IO loan rollover and needs help managing the process or understanding their options, Skyward Financial will analyse their situation, discover options and help to implement the optimal solution.