How APRA may force you to deleverage your portfolio

Discussion in 'Loans & Mortgage Brokers' started by Redom, 1st Dec, 2017.

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  1. Redom

    Redom Mortgage Broker Business Plus Member

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    Will the changes APRA have made to lending force you to deleverage your portfolio?

    This is a question investors should be considering, as lending changes may make it unsustainable for some highly leveraged borrowers to continue holding their existing property portfolio. These borrowers may be forced to sell their existing property portfolios and reduce their debt exposure.

    A couple years ago, APRA tightened the servicing requirements lenders use to assess loans, reducing the amount of money investors can borrow. More recently, they asked lenders to reduce their exposure to interest only lending & have made it more difficult for borrowers to retain existing interest only repayment arrangements. The combined impact of these changes is that some borrowers are now overleveraged, having portfolios that would not have been possible to acquire under these stricter rules. These borrowers may face a repayment increase over time & thereby be forced to reduce their debt.

    The purpose of this post is to educate readers on how forced deleveraging may happen, put a spotlight on who may be forced to sell & provide insight on what to do to prepare for this. For those that are impacted, having the time to prepare and adjust their portfolios and/or increase their buffers may be important to managing the risks associated with being overleveraged.

    How will this happen:

    Most property investors have their investments secured under the following debt repayment arrangements; a 5-year interest only term to begin with (up to 10 years for some borrowers), followed by a 25 year principle & interest repayment period.

    This means at the end of the 5 year interest only period, the loan contract is set up to have a ‘repayment increase’ to repay the principle debt borrowed. In addition to a change in repayment type, it is prudent for investors to have a buffer for potential RBA cash rate increases. APRA have named the potential for this cash flow issue as ‘payment shock’.

    How big is the impact of a swap to P&I repayments & rate rises?

    How much your repayments will rise by will depend on:
    - How much debt you have.
    - How much interest rates change over time.
    - The term remaining on your debt (is it 25 or 20 years).

    If you combine a few interest rate rises AND the need for your principle payments, you have the makings of a cash flow nightmare. This could force borrowers to sell their investments.

    Picture1.png
    The LHS shows the annual increase in repayment when an Interest Only portfolio at 4.75% swaps over to P&I repayments at 4.75%. The RHS shows the impact of a swap to P&I and a 1.50% increase in interest rates.

    Who will this impact?

    Payment shock impacts property investors as they usually have more debt on interest only terms. Who will specifically be impacted will depend on the level of household debt you have relative to your income.

    We have modelled out a guideline of ‘safe’, ‘risky’ and ‘dangerous’ portfolio sizes based on different income sizes.
    Picture2.png
    This analysis is based on a couple earning a 50/50 split of total income, renting at $400 per week with lender calculated minimum living expenses, an interest only portfolio at 4.5% that is 100% debt funded.

    Will I be able to extend my interest only period?

    APRA changes to lending criteria mean that it will be harder for some borrowers to extend interest only terms via refinances or adjustments to their loans. Specifically, APRA guidance tells lenders to re-assess borrowing capacity for those seeking to extend their interest only periods.

    This means, if borrowers have a healthy level of debt relative to their income, they are unlikely to be affected by this payment shock. For reference, we have modelled out what a healthy portfolio size is based on different income and yield profiles. The ‘green’ is healthy and represents borrowers who should have no issues maintaining interest only borrowings. Picture3.png
    This analysis is based on a couple earning a 50/50 split of total income, renting at $400 per week with lender calculated minimum living expenses, an interest only portfolio at 4.5% that is 100% debt funded.

    What should investors do to prepare for this?

    The most effective tool to managing payment shock is having liquid buffers in your portfolio to manage a potential repayment increase. Alternatively, you can simply reduce your debt levels. In the absence of these, property investors should factor payment shock risk into their debt management strategy. This includes:
    1. Knowing how your debt works. First and foremost, be very wary of strategies that involve taking on more debt to manage a debt problem. Understanding how your repayments work over time is a worthwhile exercise for property investors.
    2. Know when your interest only terms expire. This gives you a sense of where the potential risks might be in your portfolio and give you a feel for what may or may not need to be managed.
    3. Consider ways to manage the P&I repayment and a debt size you’re comfortable with. Start planning on how to bring your debt size in line with this. For example; rental increases, income additions, paying down debt, or even selling of part of the portfolio will assist.
    4. Be aware of appropriate buffer sizes that you should hold to manage your portfolio.
    5. Ensure your portfolio is adequately protected (e.g. income protection insurance, life & trauma, building insurance). It could be chaos if payment shock happens at the same time as job losses.
    In the immediate term, you may have non-bank lender options available to you that would allow you to maintain interest only terms on some of your loans. These lenders represent the 'aggressive & red lines' in the two charts above. The cost is usually higher, but the repayment otherwise lower than P&I options.

    What are the market level impacts of this?

    Payment shock hurts investors who are overleveraged. This isn’t the majority of borrowers, therefore, it shouldn’t really make a major shockwave to the property market as a whole. I suspect the regulators & lenders who have more data on the potential impact of this have already stepped this out.

    While building a property portfolio is the aim of many investors, remember that maintaining and protecting it over time is where the real rewards are.
     
  2. chylld

    chylld Well-Known Member

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    Great post, thanks Redom.

    My personal financial model was built on a balance sheet which only looks at present time cashflow, which made IO look like the best option. Only when I started forecasting 20/25 years out did I realise it wasn't! Decided to take the payment shock while we still had the cashflow for it.

    I think the trap many fall into is looking at their cashflow whilst on IO and then allowing lifestyle creep to eat up the buffer...
     
  3. Blueskies

    Blueskies Well-Known Member

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    Good post. Have recently refinanced three properties on IO at high 4% to 3.8% fixed P&I for 2 years. The repayments aren't that much more and actually nice to see the principal starting to fall. Am now modelling all future purchases as as having to stack up on P&I from day 1.

    Occurs to me that I am doing exactly what the regulator want which suits me fine. Don't fight the Fed.

    Only thing that annoys me is that it slows the rate at which I am paying down non deductable homeloan. Plan is to periodically redraw the principal to put to work in other income producing investments to accelerate this.
     
  4. euro73

    euro73 Well-Known Member Business Member

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    In today's environment, if you have ambitions to grow, most investors actually have to undertake accumulation and amortisation of debt simultaneously in order to have a business model that is shock resistant. There is no more buy, hold, harvest, buy, hold, harvest... not for newbies anyway. That model was supported by generous servicing and extendable I/O periods which just dont exist today.

    Of course, if you dont have ambitions to grow... probably nothing to see here... debt reduction is less relevant to you.

    But this is an investor forum , so I take it as a given that most readers aspire to grow, so the post by @Redom is particularly relevant to the eyes here.

    It is especially relevant to those with median levels of income, modest chance of that changing much and modest/immature yields. In most instances their portfolio /business model is being operated under I/O , low rate conditions... and wont easily survive a change to P&I conditions.

    As @Redom has pointed out , this probably represents only a small(ish) percentage of total investors overall - although it represents a high percentage of recent investors, and I suspect it also represents a fairly healthy number of more recent first home buyers who have purchased in the more expensive Sydney and Melbourne markets in the past few years as well...

    Single best thing anyone can do, no matter who they are, is to start making extra repayments onto their PPOR debt and get rid of car loans, personal loans, credit cards.... If they have no PPOR debt or other "bad" debt, next best thing is to start switching loans over to P&I earlier than planned and reduce the shock factor. From a monthly cash flow perspective, it's less of a shock to be paying P&I over 30 years or 27 years, or 26 years than over 25 years or 20 years. If that's not viable/affordable , thats the sign that you need to add extra income somehow so that it becomes viable... or sell. It would be prudent to make that decision before everyone else in the same boat as you is running to the exits simultaneously. The exit gets awfully small when everyone is trying to use it at the same time.

    Broadly, I agree with@Redom that the "at risk" investors represent a small number.... so its by no means panic stations. But like any business.. just look ahead 2,3,4 years and start planning for it.
     
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  5. Perthguy

    Perthguy Well-Known Member

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    Fantastic post @Redom, particularly this:

    Know when your interest only terms expire
    The number of people who have posted on here that suddenly their repayments increased when they went from I/O to P&I amazes me.
     
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  6. Zoolander

    Zoolander Well-Known Member

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    People probably find it tricky setting a reminder 5 years into the future when their IO period ends. Apps change. Paper stuck on the fridge fades. Tattoos however... last long enough
     
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  7. euro73

    euro73 Well-Known Member Business Member

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    A few clicks and taps on a computer keyboard and mouse will reveal all :)

    Personally, I also have a spreadsheet that shows all my loan settlement dates, fixed rate expiry dates, I/O expiry dates, etc

    And banks write to clients several months ahead of these things changing, as well...

    There just aren't any excuses for not knowing.
     
  8. chylld

    chylld Well-Known Member

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    @euro73 totally agree with everything you said. My impression is that all of us here are responsibly ambitious with our portfolios; just the way to approach it has been tempered somewhat.
     
  9. euro73

    euro73 Well-Known Member Business Member

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    I dunno.. I recall a number of young investors being quite feted on these forums just a year or two ago... and their numbers were extremely fragile , but my observation of that fact wasn't welcomed at the time... So I would have to conclude that at least some on here havent been especially responsible with their ambitious pursuit of "more" .
     
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  10. Perthguy

    Perthguy Well-Known Member

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    I regularly log into my internet banking and check a few things:

    - unauthorised transactions
    - interest rate
    - repayments are being made and are coming from the correct account
    - offsets are linked correctly and the interest for the loans is being calculated correctly
    - when my I/O period is expiring

    Investors who find out 2 or 3 years later that their offset account was not linked to their loan account are not doing their job, in my opinion.

    Similarly, investors who find out they suddenly switched from I/O to P&I are not taking due care, in my opinion.

    Investing is like running a business. It doesn't take a lot of time to monitor that your business is running well and allows you to pick up any problems early and not years later.
     
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  11. Colin Rice

    Colin Rice Mortgage Broker Business Member

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    Great info as usual @Redom

    When times are good you need to store up for the lean times cause they always come.
     
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  12. Colin Rice

    Colin Rice Mortgage Broker Business Member

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    Yep, always best to call the bank post settlement and check that offsets are linked.
     
  13. Peter_Tersteeg

    Peter_Tersteeg Mortgage Broker Business Member

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    Some are, some aren't. I get a lot of enquiries from this forum with dreams of buying 4 properties in the next 12 months. Plenty of people I see are heavily into interest only loans and it's not uncommon for people to say they want I/O for affordability reasons.
     
  14. Momentum

    Momentum Well-Known Member

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    Nice formatting Redom!
     
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  15. chylld

    chylld Well-Known Member

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    Maybe my impression was from SS days... :oops:
     
  16. Peter_Tersteeg

    Peter_Tersteeg Mortgage Broker Business Member

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    Nah. It was far worse bank when the banks would actually allow you to borrow so much that you could be irresponsible. ;)
     
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  17. Perthguy

    Perthguy Well-Known Member

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    Good times! I remember those days. :)
     
  18. Rolf Latham

    Rolf Latham Inciteful (sic) Staff Member Business Plus Member

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    An active and managed debt reycling strategy can accelrate this a bunhc, especially where you have a fair bit of ded IP expense

    ta

    rolf
     
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  19. Biz

    Biz Well-Known Member

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    To me the big problem is not being able to extend IO terms. The fact you can't borrow as much, who cares...
     
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  20. au contraire

    au contraire Well-Known Member

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    Great post and quite concerning that many people don’t seem to have an exit plan, and the banks were handing out loans anyway, which really does justify the recent apra interventions.

    A real concern is those that believe they can transition from IO to a 25 year P&I loan but don’t meet the criteria due to being late in their working life are and instead foisted with a much shorter P&I loan term with accordingly higher repayments.

    I think this will come back to bite quite a few people who got a bit giddy about potential cg in the last few years.
     
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