Ticking Time Bomb of Interest Only Loans Expiring As servicing tightens up and bank policies change I expect (and others) it to be much more difficult for people to renew the IO term of interest only loans in the future. This will probably be the case not only for owner-occupied loans but for investment loans too. The problem Someone with a large amount of debt will suddenly be hit with a large jump in repayments. Example – A person with $500,000 owner occupied debt, not deductible $1,000,000 investment debt, deductible. If the interest rate is say 4.5% owner occupied and 5% investment, the interest only repayments will be: $22,500 per year for the owner occupied $50,000 per year for the investment $72,500 in total What will happen in 5 years’ time when both revert to PI? PI will result in a higher level of repayments because each month you will be paying back principal of the loan together with interest. Over a 30 year period the amounts would be: $30,396 per year for the owner occupied (assuming monthly x 12) $64,416 per year for the investment $94,812 in total As you can see this is a big jump in repayments. But it will be worse than this because after 5 years the loan term will only have 25 years left, so we really should calculate the PI repayments over a loan term of 25 years. $33,348 per year for the owner occupied (assuming monthly x 12) $70,152 per year for the investment $103,500 in total So the repayments now are approx. $72,500 and the repayments in 5 years will be $103,500. That is a $31,000 increase which works out to be 42% more than what you would be paying now. If you entered the loan before your loan terms on reversion to PI may be calculated on shorter remaining terms and this would increase the repayments even more. Some say reverting to PI doesn’t matter as rents will have increased during this time. Hopefully, rents will increase over the next 5 years, but it would be unlikely they will increase by as much as 42%. Others say it doesn’t matter because you will be paying down debt. It is a good thing to pay down debt but the extra cash flow could hurt people. Imagine those retired suddenly having to find an extra $30,000 or so per year to pay back to the bank. This could be enough to force you to work! The main problem as I see it is that the repayment of the non-deductible debt will be delayed because funds will be diverted to the paying down of the investment debt. This will result in less tax efficiency which means more tax will be payable. In turn, this means less money to pay off the non-deductible debt. It could lead to debt recycling in reverse. Add to this the effect on a macroeconomic scale. Probably about 95% of investors will not realise or forget their loans will revert to PI and of the 5% that do remember, I expect 95% of those will probably not plan for it. This could lead to a large number of people being suddenly hit with unexpected extra expenses. This could ruin retirements for some and for others it could cause them to want to start selling one or more properties. Plan for the year 2021. What can you do to limit the effects or delay the inevitable? 1. Pay off your non-deductible debt within 5 years (or before your investment loans revert to PI). 2. Extend interest only periods as long as possible now – 10 years if you can. 3. Extend loan terms whenever you can. 4. Build up cash in offsets of IP loans where you have no non-deductible debt. 5. Pay IO on a PI loan perhaps, see Tax Tip 46: Want to Pay IO on a PI loan?