If you have read the news lately you would most likely heard that there are many that believe the current level of interest only borrowings in Australia is a ticking time bomb, and we as a nation of property loving investors are headed for disaster, addicted to interest only debt, and buying houses on the never-never plan. I mean, it’s not like the Media to make a good beat up over news like this, is it?
The Plight of the Regulators
In light of APRA placing a cap on Australian lenders with how much new Interest only lending they can write each month, and banks making it very hard to access Interest only loans, many money lenders have even increased interest rates on all of their existing loans clients with Interest only loans, what is the real story when it comes to this type of lending?
Are the regulators concerns justified? Will this result in many of these Interest only borrowers facing huge shocks in the future when the Interest only term (usually 5 years) matures and being forced to pay Principal and interest? Or is it possible many clients have received sound financial advice by a trusted adviser that has led them to the decision of placing some of their borrowings on interest only, and it is part of a larger strategy, in some cases to pay down personal debt first with the additional cash flow created by Interest only loans on their investment borrowings.
There is evidence that in some cases many borrowers are paying interest only loans to free up their cash flow for other luxuries while they place their home borrowings on the “never-never” plan of paying it back when they sell it based on the assumption that the home will always be worth more in the future. This is certainly the case in some of the southern capital cities where many borrowers never intend on paying down their home loans, however I do not think that this is the norm, and borrowers / investors are now very savvy with loans due to the information and financial calculators readly available.
I believe that many borrowers use interest only as a tool to maximise their cash flow and direct it to repaying non-deductible debt, and has certainly been the case with many of the clients that I work closely with. This is a strategy that will now be much harder or more costly to achieve, with many lenders now reducing the Loan to Value (LVR) on Interest only loans (most below 80% / some below 50%). Interest rates too have been increased on IO loans to ensure that anyone wanting to continue on the Interest only strategy will need to pay a premium for the pleasure, sometimes up to 0.5%. This can often remove the overall benefit of selecting an interest only strategy in the first place.
So is interest only loans Bad? Not necessarily, but it is something that needs to be understood by the client. Interest only will always cost the borrower more over time than a P&I loan, there is no denying that, and now the rates are even higher for IO loans, this cost will increase further. The repayments will always increase at the end of an interest only period as well, sometimes up to 20% above the interest only period.
So Now What?
Now more than ever, before committing to a loan you really need to ask yourself a couple of key questions to determine what sort of loan will be most suitable for your situation. Firstly, determine what is more important to you with your loan, such as:
- a lower interest rate
- a lower repayment
- a higher borrowing capacity
While I believe that most lenders have seen this regulatory involvement as an opportunity to increase margin on existing loans (that have absolutely nothing to do with the cap enforced by APRA), ultimately it is still a positive to pay P&I over Interest only where possible, as you will pay significantly less interest on the loan in the longer term.
What does all this mean for you? Ultimately it may be time to reconsider P&I repayments on your investment property loan. The advantages are you will start reducing principal on the loan, thereby increasing the equity you have in the property, you will be able to negotiate a much better interest rate with most lenders, and you will ultimately save money on the loan by reducing interest cost when repaying principal. You will however, have a slightly higher repayment commitment going forward. With interest rates still so low, there is no doubt they will still be affordable for you though.
If you would like further advice around interest only loans or Principal and interest repayments, please feel free to call and discuss further.