For many years property investors have reaped the benefits of securing interest only (IO) loans for their investment properties but this trend is about to take a downturn as many lending institutions crack down on interest only loans while others are substantially increasing their IO rates to for both current and future borrowers.
Why Is This Happening?
There is of course, a reason for this. The banking regulatory authority, APRA (Australian Prudential and Regulation Authority), is forcing mortgage lenders to limit their interest only loans to 30 percent of all residential loans (down from around 40 percent previously).
According to a letter sent by APRA to all authorised lenders dated the 31st of March 2017, it expects all lenders to “limit the flow of new interest only lending to 30 percent of new residential mortgage lending”.
Furthermore, APRA have restricted the loan to valuation ratios (LVR) to below 80 percent with strong scrutiny of instances where the LVR is above 90 per cent.
This has meant that many of the major lending institutions such as the Commonwealth Bank, Macquarie Bank, Citi, ME and Westpac, just to name a few, are starting to severely restrict the amount of interest only loans that they will grant to new borrowers.
In fact, some of these lenders, such as Citi, have even banned owner occupiers from taking out interest only loans whereas others have increased their IO rate by as much as 0.50%.
This is a sure indication that lenders are now actively pushing borrowers to take out P&I loans rather than encouraging them to consider interest only mortgages.
So What Is The Difference Between IO and P&I Mortgages?
Put quite simply, with an IO mortgage, the borrower only needs to make the interest payments on the loan whereas the principal remains unpaid. This has been very popular with property investors to help them to increase their property portfolio because IO repayments have been generally lower than P&I repayments and are totally tax deductible.
The general idea behind this type of loan is that the investor will hold onto the property for a number of years in the hope that it will increase in value and therefore equity. Then the investor would either sell the property to repay the loan and use the remaining equity to buy another property or hang onto the property and still use the increased equity to secure another loan to purchase an additional investment property, thus increasing his or her property portfolio.
Problems have started to arise with this model in recent years, especially in Queensland, where property values have not increased as expected, with some properties even decreasing in value.
On the other hand, a P&I mortgage requires the lender to pay not only the interest but also a portion of the principal sum as well so that over the term of the loan, the mortgage would eventually be totally repaid.
To quote an example given by Macquarie bank’s analysts, a borrower with a $500,000 loan would be $6,000 better off with a P&I loan after 5 years and $12,000 better off after 10 years of repaying a P&I loan.
To show you exactly how this works, we used the Interest-Only Mortgage Calculator available on ASIC’s Money Smart website to calculate just how much extra you would pay if you were to take out an interest only loan for 5 years which would then switch to a P&I loan for the remaining loan term. As you can see, after 5 years the monthly repayments almost doubled.
So What Do The Lending Restrictions Of Interest Only Loans Mean For The General Investor?
For the majority of property investors, the lending restrictions on interest only loans need not be bad news however. Firstly they’ll enjoy the benefits of a lower interest rate when switching or taking out a new P&I loan and some lenders are even waiving the usual fees to allow borrowers to switch their IO loan to a P&I loan.
Another benefit is that as investors start to pay down the principal amount of the loan, their equity in the property will increase more rapidly, allowing them to then use this increased equity to purchase another investment property without having to necessarily sell the current one.
This is especially beneficial if their investment property is positively geared as the increased repayments won’t be too much of a strain on their cash flow plus having an offset account can mean that they can save even more on interest.
So What Should You Do If You’re A Current Property Investor Or Want To Get Into The Market?
The most prudent thing that current and future property investors can do right now is talk to a mortgage broker who understands what’s currently going on in the loan market.
A knowledgeable mortgage broker will be able to sit down with you and help you to work out a strategic plan based on your current circumstances and on what you want to achieve in the future. Generally speaking, property investing should be a long term strategy for any investor and it’s important to plan out this strategy to ensure a good financial future for yourself and your family.
In addition, a good mortgage broker should be able to anticipate changes in the market and help you to ensure that when these changes happen, you’ll be ready for them because you’ve worked them into your overall investment plan.
The most important thing though, is not to panic right now and look for the cheapest interest only rate that you can find, as this rate could easily go up in the near future. Talking to your mortgage broker may save you thousands in the long run if you decide to switch to a P&I loan now even if it means that you may have to sell one of your properties to help fund the slightly higher repayments.
By Collins Mayaki
HashChing Partner Broker