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As the biggest Australian property markets enter the softening phase, investors are warned against falling off the ‘interest-only cliff’. Should they jump ship and switch to principal-and-interest loans?
Using interest-only loans simply means paying only the interest on the loan and not the principal amount borrowed. Essentially, investors are merely servicing and holding their debt instead of paying them off.
Most investors have incorporated this into their long-term strategies when the property market was following an upward trend. However, the game of finance completely changed once the property boom in Sydney and Melbourne ended and their markets saw consistent declines.
Traditionally, once their interest-only period ends, investors extend their use of IO loans until they have enough cash flow to pay off the principal amount borrowed.
Nowadays, following the lending interventions by regulatory bodies, extending interest-only periods has become much harder, thus, forcing some investors to switch to standard principal-and-interest loans and face higher mortgage repayments as they start to pay principal. This could mean dealing with repayments that are up to 40 per cent higher than what they are used to.
According to mortgage broker Marissa Schulze: “To extend interest-only period now requires a full risk assessment based on new borrowing rules. If they actually applied, they may not even be able to afford the debt they've currently got to be able to refinance.”
These new lending rules include examining the borrower’s living expenses, down to the simplest black coffee and the cheapest app subscription.
Some lenders have also begun operating on higher assessment rates and requiring a declaration of investment property-related expenses. Others may only consider 80 per cent or less of the rental during assessment and reduce or completely remove negative gearing from their servicing calculators.
Investors who have a 30-year loan term and only had their interest loan for about five years are practically safe from the ‘interest-only cliff’, Ms Schulze said. Even if they are forced to revert to principal-and-interest loans, they have around two decades to pay off their debt.
Conversely, investors who have already renewed their interest-only loan for a few times over the course of their loan term are more likely to bear the brunt of the fluctuating markets.
According to the mortgage expert: “Perhaps they got a 30-year loan term and they got 15-year interest only terms. As you come to the end of that, you have to repay the entire principal amount over the remaining 15-year term—we’re talking about the repayments doubling.”
“That's going to have a massive impact on your cash flow and as you know, cash flow is everything when you've got an investment property portfolio,” she highlighted.
Ms Schulze strongly advised investors to be proactive in managing their home loans, particularly in today’s tighter lending environment.
“Don't wait for six months before your interest-only period extends. If you can see that you've got some interest-only on your book and that's going to be expiring over the next two to three to five years, talk to your broker now to make a plan,” she said.
As the lending interventions are expected to stay and become the ‘new norm’, property investment is bound to become a more complicated game of finance, ultimately impacting wealth-creation journeys for the long-term.
Apart from taking the time to understanding the changes made in the lending environment, investors are advised to review their servicing capacity and consider multiple financial possibilities and implications for years to come.
Engaging reliable mortgage brokers can help you improve your serviceability and maximise your earning potential even in fluctuating markets.
According to Ms Schulze: “It's a matter of having a look at their servicing capacity at the current present time. If they're in a position to do something about it now, then I encourage them to do something about it now so we could refinance the loans to new 30-year loan terms or bring forward the P&I repayments and reduce the burden to some extent as they have a longer period of time to pay the principal.”
“See how your financials are possibly going to look like over the next few years to ensure that you've got a year where you can have strong borrowing capacity to refinance your loans at a particular point in time.”
At the end of the day, it’s all about finding the right financial strategy that will allow you to remain in the market and continue growing your portfolio, even if it means setting a tighter budget to lower your living expenses and ultimately make sure that you can afford the loan moving forward.
“It's only a matter of being proactive and planning in advance of the interest only expiring. It is difficult, but if the alternative is losing all your properties, then you have to take action,” the mortgage expert concluded.
Interest is the amount of money charged by a lender or financial institution for a loan, which is calculated as the percentage of the principal amount paid over the loan term.