20 Jul The interest only loan sting
Recent moves by the banks, pressured by changes to borrowing requirements to hike rates on interest only loans with the possibility of more to come, has brought into question the appropriateness of interest only loans for investors. Although the media has provided numerous articles promoting the “switch”, we need to look more deeply at the implications.
Restructuring your existing loans is not as simple as it might seem and investors should seriously consider a number of options whilst the banks are offering ‘deals’ because potential rate rises and tightening of lending criteria could otherwise result in investors being forced to sell.
Principle & Interest or Interest only?
In the past, interest rates on principal and interest loans were essentially on par with interest only loans. Investors could arrange for interest only terms and retain the loan principal at static levels for a long period (loans were generally for five years but most lenders were more than agreeable to extend the arrangement). This allows investors to match their cash flow expenses with the matching benefit of an interest payment tax deduction.
The cheap access to interest only loans has allowed property investors to borrow large amounts and still have a comfortable cash flow position. Thus investors have been able to enjoy strong returns as their assets rose in value and adopt a plan where they will repay the debt when they sell out.
With recent interest only rate rises, investors are now being urged to consider the wisdom of moving to a principal and interest arrangement where the rates are now given preferential treatment. Given rate differentials on loan types are growing, investors should be carefully considering the real costs of retaining an interest only (IO) loan as opposed to restructuring to a principal and interest (P&I) arrangement.
The following table shows the Commonwealth Bank loan standard rates, from 7 July 2017:
As you can see, the flexibility of not needing to repay principal on your loan is now charged by the Commonwealth Bank as a premium for the service!
Why wouldn’t I just switch to a Principle & Interest arrangement?
A number of articles in the media have begun preaching the benefits of investors making the move to a new loan as gospel. Unfortunately, moving from interest only into a principal and interest arrangement is not as straight forward as it appears on the surface because the new loan under principal and interest comes with a commitment to repay the outstanding debt over the term of the loan. The following example should illustrate the potential impact on cash flow of making the choice!
Assuming that I am a leveraged property investor with $1,000,000 in loans and I’ve maximised my lending so that my income just services my lifestyle and my interest only arrangements.
Further, I’ve done the right thing and arranged my loan at better rates than the standard variable rates, I’m currently enjoying the low rate of 4.25% on my outstanding debts and as such my repayments are a comfortable $3,542 per month, as shown below.
Unfortunately my lender has just let me know that they are raising rates by 0.3% p.a.
Suddenly my loan repayments have annoyingly jumped up by $250 per month as per the next illustration.
I can look to put up the rent by $50 a week next renewal but I will also take the risk that the renters may vacate. So my safest option is to look into reducing my spending – no more smashed avo on toast, I’ll just stick to my coffee and raisin toast!
But actually, I’d prefer not to pay the bank the extra and so I’ve decide that I won’t accept this interest hike and I’ll refinance my loan at the cheaper interest rate under a principal and interest rate, which my broker can still arrange at 4.25%.
Unfortunately, when my broker comes back to me with the monthly repayment schedule for a 30 year loan I’ve fallen off my chair. This is because to arrange the new loan and keep my favourable rate I now have to find another $1,377.73 a month!
What can I do?
Whilst this is a hypothetical situation, the illustration should ring alarm bells for any property investors that have large borrowings and who are sweating on potential interest rate rises.
Quite simply, the potentially advantageous move to save interest costs by restructuring to a principal and interest loan may prove to be too expensive not because of the interest cost but because of the commitment to repay outstanding principal.
I suggest that this is not a problem to be ignored and those that take action now by discussing their situation with their advisers will be better positioned to cope with any further rate rises without needing to trade out of assets in a cooling property market.
At Orion Financial Group we are well positioned with our in-house advice team and our relationship with our mortgage broker to guide you through the available options. Please contact us on 02 9633 5530 or via our website.