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By 2020, around 200,000 interest-only loans worth over $480 billion will expire and reset to principal-and-interest loans. In the tightening lending environment, should investors let the reset happen or extend their interest-only loans?
Nearly half of the loans written between 2014 and 2015, or around 40 per cent, are interest-only. These loans account for around 1.5 million borrowers across Australia.
According to Atelier Wealth’s Aaron Christie-David, as the growth of interest-only loans is still capped at 10 per cent, most of these loans from five years ago are coming to the end of their term. Between 2018 and 2021, a large number of home loans in the country is expected to be principal-and-interest.
During this time, mortgage repayments can hike up to $7,000 a year for most investors, which could significantly affect the cash flow of investors as there will be less time to pay off the principal amount borrowed.
Mr Christie-David said: “One thing we've caught people unaware of is it actually rolls onto a 25-year P&I term, not a 30-year P&I term. If you can afford it, great. If you can't afford it, you're in problems and it's going to put stress on you.”
A lot of investors would think to sell their properties to avoid bearing the brunt of the ‘interest-only’ danger zone, but Mr Christie-David advised them to stick to their assets for as long as they can in order to ultimately maximise its wealth-creation potential.
While the lending interventions implemented by banks and regulatory bodies have definitely shaken the field for borrowers, the property market is nowhere near any significant, life-changing crash. Instead, Mr Christie-David described the coming years as a storm that investors simply need to weather.
“If you bought this property for a reason, stick to your guns. The game plan’s changing a little bit from what the banks are doing, but you really need to get comfortable in your own skin and say, ‘I bought this property for a reason. We're about to come into a bit of a storm but we're all going to go through it.’”
Years ago, interest-only loans allowed Australians to get a foot in the tightly-held property market while maximising tax deductions, enhancing cash flow and ultimately growing their asset base.
Fast forward to current times, it’s safe to say that this strategy worked too well for most investors. Through the years, affordability has become a major issue across housing markets in the country, which is why the government and other regulatory bodies have made moves to slow down lending, highlighting the importance of responsible lending and borrowing.
These policy-driven changes have impacted the approval of home loans, particularly interest-only. Investors who have used interest-only home loans starting 2014 or 2015 are more likely to face the reversal of their loans to principal-and-interest rather than be approved for an extension of the interest-only period.
According to Mr Christie-David, there are three main reasons why interest-only loans could be the harder choice in the tightening lending environment.
First, and the most pressing of all, lending has gotten tougher due to stricter credit assessment. Banks and other lending institutions have put emphasis on living expenses as a new criterion for the approval of mortgage applications.
“Some people may find refinancing tougher because their loan may be taken under car lease. Banks have got more scrutiny around living expenses, which wasn't around in 2014, 2015. Naturally, people are finding it hard to get lending,” the mortgage expert said.
Second, the level of supply and demand has been affecting the rental market. Therefore, regulatory bodies aim to slow down investment lending to ease the impending oversupply in the market, particularly with units.
“We're seeing a drop in demand for property because the supply of credit has gotten a lot harder as well. Over the next few years, we will see a record number of unit supply coming onto the market. Meanwhile, we've seen very little growth in rent across the property market.”
Finally, the slow down of capital growth. “People are banking on growth. Again, the new supply coming onto the market will be pressing down on capital growth.”
“You overlay all those three and you got a real combination of headwinds for people. If you pull the crystal ball at 2014, 2015, you could never see this coming,” the mortgage expert highlighted.
For investors who are adamant about extending their interest-only loans, Mr Christie-David said that it won’t be as easy as the previous years. At the end of the day, like most mortgage applications, it will come down to their credit assessment.
Essentially, investors will have to do a whole new application in order to be considered for an extended interest-only period.
“Right now credit managers are looking for reasons to say no rather than say yes. We're stressing to people—be upfront with all your documents, be upfront with all your information. Don't leave anything undisclosed because that's just going to put you in a really bad position,” he said.
While it’s definitely going to be harder and more complicated to acquire interest-only loans or extend interest-only terms moving forward, there will always be a market for the specific type of home loan.
Banks will continue to offer interest-only home loans and mortgage brokers will continue to be able to have them approved. However, continuing on the interest-only path will require more engagement and guidance with property and finance professionals.
Mr Christie-David said: “You need to find the right broker to find the right lender for you. If your broker hasn't packaged a deal up correctly, it may not actually flow with the banks.”
Knowing the risks and complications involved, is it really worth it to continue on this path or should investors just wait until interest-only loans are more viable again?
According to the mortgage expert, cash flow is one of the main reasons why investors will insist on extending their interest-only terms.
Those who are still aggressively growing their portfolio would want to minimise their mortgage repayments for as long as they could in order to capitalise on the available purchasing opportunities. On the other hand, some investors may want to pay off the principal on their place of residence first.
Regardless of the reason, the investor must be able to justify their application for an interest-only loan to the banks, stricter lending regulations considered.
“Some have really good astute financial planning or accounting advice that fits into their strategy. It may be around investing in shares or managed funds into their SMSF. So, interest-only definitely has its place, but it’s not going to be for everyone right now,” Mr Christie-David said.
If, at the end of the day, the investor is unable to extend their interest-only terms, all is not lost, he said. In fact, it could be better for their portfolio in the long run.
After all, the most important benefit of switching back to a principal-and-interest loan is the ability to pay off your debt at a possibly lower interest rate.
“Quite honestly, the numbers are on a higher interest-only rate versus a low P&I rate. Sometimes, it's not too far off. So, you could choose to start paying down the debt while it's still cheap.”
Whether you have decided about the next step or not, if your interest-only loan is coming to an end, it’s worth the time to sit down, reassess your investment journey and have a talk with your investment team about future financial strategy.
Before ultimately making a decision, be aware of your current financial situation, the status of your portfolio, the state of the property market and the existing rules of lending. Most importantly, know your goals, capabilities and limitations as a property investor.
Moving forward, securing finance will definitely be more challenging, which is why investors are strongly encouraged to be in control of their finances and their assets.
Mr Christie-David said: “Just start with having a chat and knowing your numbers. If you've got a broker, go back to them, get them to call the bank and let you know exactly when your loan's due to expire and what options they can do to retain that business.”
“I think having that knowledge is going to give you that confidence and be empowered to become a better investor.”
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.